Designing better futures

The book Volatility Trading has lessons about risk for many

Volatility Trading is a good tool for learning about the ins and out of volatility.  Volatility Trading is accessible and informative in the same style as Ernest Chan's book, Quantitative Trading.

Both Quantitative Trading and Volatility Trading offer tutorials from helpful practitioner teachers.  There is a mix of quantified academic rigor in the form of teaching about the tools of the trade and real world humility.  

I Don't trade options or volatility so why should I care?

One of the flaws of the financial system today is practitioner's belief that volatility is risk.  This is a sad case of using the wrong metric to describe what is experienced by the investor or allocator.  This failure occurs at the personal and billion $ pension fund portfolio levels where trustees from august institutions hold sway on allocation committees.

Volatility Trading begins explaining the basics of calculating Volatility and then launches into 6 separate ways to measure volatility.  A risk manager's ears should perk up now.  Portfolio Value at Risk VaR which is driven by volatility and co-variance can vary significantly depending on how things are measured. 

Like the old joke about the accountant, engineer and lawyer goes.  When asked what 2+2 equals, the accountant answers 4, the engineer answers 3.999 and the lawyer looks around and says, "what would you like it to be?".  Most quantitative risk measurements are elastic and prone to subjective biases, ask Moody's or S&P about CDO ratings. 

If you are on the receiving or delivering end of a VaR report or work with any derivative whose value is determined by path dependence you might want to perk up and take a look at this book as it is a good introduction to the field of volatility and indirectly hedging and risk.

If you have a deep background in mathematics etc, the Volatility Trading's math components may feel introductory and light.  For math newbies, things are clearly articulated and laid out like a useful dummies guide to volatility, hedging and money management. 

Living risk is very different from modeling it.

  Sinclair does a good job of trying to explain what it is like to have a position on and go through drawdowns.  Sinclair quotes Mike Tyson in the opening of one chapter, "Everyone has a plan, until they get hit."

Again for risk managers, learning to be more skeptical of volatility by reading someone who trades it for a living is useful.

The book also touches on Kelly money management techniques which can be a useful way to think about leverage, exposure and ultimate trading goals.

Volatility is a limited measure of risk that is detrimentally overused.

Volatility is simple to calculate, easy to apply across asset types and easy to understand. Unfortunately, that doesn't mean it is as worthwhile as it gets held up to be.  Volatility tells you much the car and driver have swerved in the past. Volatility doesn't tell you if the car or driver are going to get you where you want to go.

Risk & Return may be approximated by a positional utility model

Here is an interesting and pretty lengthy paper by Eric Falkenstein.  It consists of 2 major parts a synopsis of failures of the typical risk reward relationship assumed in finance and an explanatory thesis involving individual agents who have envy in the pursuit of positional goods.

The refutation of the risk / reward relationship is well trodden ground and Falkenstein provides a nice summary by rounding up quite a few example papers.  These include everything from bond yields, call options and even the risk reward of investing in G, PG and R rated film productions.  If you are interested in getting to grips with where modern finance fails, this is a good paper to review and then pursue the cited sources.

Refuting existing dogma by rounding up the relative papers is well and good, but sadly efficient market theory in regards to risk and reward will remain taught even if with caveats.  The meme survives until replaced by another. 

Admitting ignorance, even when correct doesn't sell.  Admitting ignorance doesn't fill $40k/year MBA classroom seats.  Admitting ignorance, doesn't sell books, consulting hours or videos.  Admitting to shared ignorance doesn't sell shares, close the deal, fill the conference center or win the day in the job interview.

No. For most it is better to play the game, admit the dogma may be farce and replicate the farce that is the return risk relationship held up by efficient market theory.

The more interesting part of the paper is Falkenstein's attempt to bind the micro and the macro of finance using individual behaviour and macro outcomes.  Behaviouralist economics typically focuses on the counter intuitive nature of the individual.  This novelty then gets distilled into entertainment a la Freakonics type books.

Falkenstein rightly acknowledges and attempts to model systems using agent behaviour, including not the "homogenous" popular agent of the rational man, homo economus found in traditional economics, but rather an agent who seeks positional goods and perhaps purchases ascribed or achieved status among his or her peers.  This complex agent approach is probably a better reflection of the real drivers of economy.  It is also devlishly complicated model.

The paper's conclusion is that the model put forward better approximates real outcomes.  I must profess to having neither the skill, nor resource to credit or discredit the thesis in the paper or the underlying model.

I like where Falkenstein is going and wish other would follow.  It is the realm of complexity and therefore potentially intractable, but I would rather have a narrative or weak theory lacking in mathematical rigour, than a rigourous model that is wrong. 

Better to have no instruments when flying a plane than overly believing in a flawed instrument and acting on it.

A good empirical argument for behaviour driving value is the significant value created by brands.  Brands have no rational economic value, but are merely social signals used to convey some value to others or ourselves.  The brand message or function varies based on the positional objective of the good or service.  Branding often allow firms who own a position to extract a price premia and thus build value at the bottom line.  

My own thesis on the function of brand varies depending on the good or service, but breaks down crudely into the following:

• Scarcity and desired social status signally via a visible considered purchase: Rolex, Mercedes, Abercrombie & Fitch, Trump etc.
• Consistency and familiarity of a repeat / impulse purchase: Tide, Marlboro, kellog's corn flakes
• Shared social ritual and repeatable quality signal: Dunkin donuts, Starbucks etc.
• Personal and social Attribute signalling via a halo effect: Nike, Addidas, Abercrombie & Fitch, Grey goose vodka etc.

Efficient market theory is the output of a human process and therefore a social area of research.  This puts market theory beyond most of the simpler models thrown at it. 

Most finance and economics participants will admit that the volatility, risk reward model is flawed.  Unfortunately ignorance doesn't sell and bad dogma is better than no dogma for most. 

The agent based models approach while probably correct is currently too complex for most to be consumed and regurgitated in the education and research milieu.  The problem of a general economic belief system itself may thus be intractable until the proper language, framework and tools makes it easier to disseminate and digest.  In economics we are still trying to explain the behaviour of individual particles when what we want is a way to take the temperature of a system. Reward vs. risk (volatility) is no thermometer.

Could you disconnect, even if you wanted to?

Here is an interesting map from William Easterly's site AidWatch. It shows the distance from major cities as a function of geography and time.  Most of us are a few hours away from each other.

 

A few things to consider when looking at a network diagram like this:

1. People and things spread fast
2. Ideas spread faster
3. Feedback loops amplify and intensify certain things
4. Individuals can't really opt out of this process easily

All of the above are true for ideas, emotions, things and the human condition in general.  The village is shrinking.  Increased competition in whatever form you imagine it (resource, economic, innovation, improvements) will accelerate and be amplified in such an environment.  Margins shrink as things get more connected.  The positive externalities of competition flow to customers. 

Warren Buffet pointed out 10 years in 1999 that the automotive and airline industries are great examples of global growth industries with limited investor economic output, but significant customer benefits delivered.  Bigger markets aren't always more competitive.  Globalization means fewer economic moats.

Bigger and more connected is different.

Full disclosure, the most remote, I have ever been was in 1992 when I was in the sub-Sahara in Ngigmy, Niger brushing up my anthropology field work skills in a village that took 3 days to reach via bush taxi, market car and finally foot. While staying in this remote village, I met an elder who eventually asked the biggest question on his mind of a young white American. In Hausa via a translator. I was asked, "Do you know Michael Jordan?"

An anthropologist looks at Transaction taxes. Why 2014 might look like 1914.

There is a lot of talk about a transaction TAX in the US.  One can argue whether it is punitive, driven by vigilante populism or a legitimate safety mechanism a la Tobin.  One of the sub-fields of anthropology is archaeology, the science of looking through dead people's  junk in an act of guessing how people believed, behaved and organized themselves into cultures. 

Stamps are a useful way to revisit transaction taxes. 

One of the more recent US transaction taxes on stocks was initiated in 1914 and then increased later in the 1930's to help pay for the Great Depression.  New York state itself imposed a tax on stock transactions in 1905.

The stamps for the federal transfer tax are affixed to this document shown to the left.  This documents records the sale of 33,973 shares of Stutz Motor car company.  My great grandfather used to own a Stutz Bearcat, in small town Iowa.

For those interested in Philatelic fiscal self-flagellation visit this site with more tax stamps.

The  1914 US transactions tax of %0.20 stayed in force until 1966.  Any good tax is food for politician zombies and won't be rescinded easily. Today's proposal would see a %0.25 tax in place.  That is equivalent to $50 per $10,000 worth of shares bought and sold.  

The gold bugs may want to look back at the past and have a look at the silver tax stamp to the left.  A spike in gold is one thing, a sustained price level reflecting a decline in the dollar may seem like low hanging fiscal Fruit for the tax man.   $3,000 gold for a sustained period could bring the label hoarder thrown at the gold owner.  A gold tax would not be surprising.

In the book, The Leopard, the old prince watching the empires of feudalism falling and the new empires of industrialist Italy rise, says that, "all things must change so that they may remain the same."

When the federal transaction tax was repealed, California decided to keep it. One could easily imagine that happening again.

The current and looming fiscal challenges will most likely mean govt. self justification for new forms of taxation. 

French royalty used to say the goal of taxation was to pluck as many feathers from the goose as possible with minimal honking, today one has to keep the populist pundits confused and tax indirectly and with slight of hand.  a bit of stimulus here and there and then some obscure slight of hand, such as the AMT, which slowly captures everyone. 

The Romans invented tax outsourcing by hiring tax farmers. 

The protesting of transfer taxes has taken many forms including tea parties.  One of the more passive forms of protesting the transfer tax was to affix a stamp next to the tax stamp indicating that the original stamp was affixed under protest as seen in this image. Source here.

 

Derivatives traders should be wary.  CDSs with their huge notional amounts probably have politicians licking their lips.  The CDS tax seems almost like winning the political trifecta for politicians of a certain ilk. The CDS tax arguments which I don't support or refute would read something like this:

• Large taxable notional amounts
• Slows down the mega trillion dollar derivatives machine
• Forces the more questionable players offshore
• AIG et. al retribution
• Too complicated for the general public to argue the case against

Here is an old grain futures tax stamp from the Updike grain company.  Source image here.

Archeology today involves trowels, brushes and patience.  The future archaeologist will probably spend time digging around server logs, which seems like less fun than looking at stamps.

The mother of all transfer taxes is the federal Value Added Tax.  For those advocating a federal securities transfer/transaction tax, be careful what you wish for as precedents set can be powerful things. The US has  a dangerously short debt duration and looming mandated fiscal deficits.  A federal VAT gets easier to justify in DC with a AA debt rating, but that is something to be discussed in 2011...2-3% federal VAT sounds about right.

Full Disclosure:

1. I am just finishing up work on High frequency trading strategy in c# with +3.0 Sharpe ratios  so would suffer directly from a transaction tax. 
2. I would like to have seen my great grandfather riding in his Stutz Bearcat, it sounds swanky.

Talk to the hand...of the free market.

More quality tom tommorrow here.

Twitter is glance

Twitter?  Here is a video articulating in a funny way that Twitter has not only jumped the shark, but jumped the Fail Whale as well.  

I would pose a counter argument to the Twitter fail whale, but first one has to understand what twitter is and what it does. 

Twitter is the technical expression of the physical concept of glance.  Glance is how humans relate at the most superficial level.  We glance to see the emotional, physical and engaged state of those physically around us. 

An interesting socio-biological hypothesis highlighted in The third Chimpanzee by Jared Diamond author of Guns Germs and Steel, is that the very size of the whites of the eye or sclera evolved functionally so that we could monitor each others directed glance.  Consider the change in your behavior when you can't see where people are looking?  When you wish to engender trust you take off your sunglasses, unless of course you are in LA or going through a self conscious hipster phase.

Glance is our first level of social interaction, our outermost degree of connectedness and intimacy. 

Social gaze allows us to monitor and feel connected with others.  Being in a bar isn't about drinking, it is about capturing a furtive glance or flirt that may escalate into something else.  Glance is about feeling engaged, accepted and connected at the most elementary level.

Twitter allows that.  Twitter is currently the easiest tool for sending or receiving social glance publicly.  The desire to be aware of others or to make others aware of us is innate.  Twitter or any medium which facilitates public/private glance will be popular, one can argue the oldest and shortest twit is the emoticon, the digital facial glance proxy.

Logo's and brands are physical glance tools that allow us to signal at a glance our values or those values we purport to telegraph.  Whether it be a sports team, individual athlete, style, wealth, power, sense of humour, ascribed social position etc.  We first and foremost communicate physically using our clothes, logos etc. combined with an awareness of giving and receiving glance among shared symbols.  Branding is the use of money to cultivate shared social values for a set of glanceable(sic) objects or relatable (sic) experiences.  Consider how Disney does this at physical park level, shared memory via narrative and finally logo/ icon level.

Twitter facilitates Social Glance creating a slightly closer social space.  It is as useful or as banal as those with whom you choose to exchange glances.

Glance is innate, intimate and superficial at the same time.  The desire to glance or be glanced is not going away, it will manifest itself in different ways technically.  Blogs, Twitter, Mood messages etc. are all digital manifestations of glance, expect to see more of them. 

A tough to get a hold of book on how and why we react to various media is The Media equation.  Don't let the unusual cover put you off, it is a fascinating distillation of social science research into how we react to media of all types physical and digital.  The book is worthy of consideration by anyone involved in media, interaction or design.

Hedge Fund mortality approaching 30%

Just looking at some 12 month rolling data charts from Hedge Fund Risk Monitor. 

I thought mortality would get to 40% based on back of the envelope calculations.  Running a fund isn't as easy as it looks, the magic numbers are 36 months solid operations and $100m assets under management before the Fund of Funds start looking around.  Here are some crude estimates I compiled on the business of running a fund what incomes have been like lately.

Here are some graphs about the industry from earlier in 2009 courtesy of Deutsche Bank.

My own opinion that inflation adjusted strategies will be relevant in the coming years and a view in regards to hedge fund half lives.

Hedge funds are famously opaque and the major databases all kind of overlap, but it is a foggy industry so take everything with a pinch of salt.  Most hedge funds don't explode etc. they quietly fold and return investors money.  We only hear about the ones that don't go quietly into that good night.  It is important to note that with the exception of outright frauds, no funds posed systemic risks since LTCM in 1998.  Everyone weathered the storm pretty well.

It was those hedge funds in drag (AIG, Bank with SPV's etc. that caused the problem).  Like the saying about about risk  It ain't what you don't know, its what you know that ain't so.  Those regulated institutions AIG, BEAR, etc. weren't big banks and insurance firms with AAA ratings, they were really something else altogether.

Anthroplogist / historian/ social scientist humour the Beatles 1,000 years on...

Trained as an anthropologist and studying a bit of archaeology and art history, I can totally appreciate that this is probably closer to the truth than these fields would like to admit. ht The Technium

Potential Energy revolution

I used to be Chief Analyst for Starlab an Advanced research lab modeled on the MIT media lab in Europe.  I have also spent 2 years researching renewable energy investments for hedge funds etc. 

The major issues of energy are storage density, distribution, availability and cost.  My own personal storage bias for the future is ultra-capacitors.  The energy technology shown below is remarkable in terms of cost, storage potential and the ability to remake the world.  

If the technology is stable and distributed it will change the power industry globally and most likely in non-grid dense countries first, where adoption of feasible storage means off grid power from an intermittent source becomes viable.  If you sell power why compete with existing infrastructure that delivers @ $.10/KwHr when you can find small off grid villages willing and happy to pay $0.40.

Here is perhaps the most interesting video on energy I have seen in the last 5 years.  If you are interested at all about energy it is worth the 20 minutes.  Here is the company  Sun Catalytix that has been formed to commercialize the technology from Dan Nocera.

Warning this is subtle and the impact won't register with most. ht Paul Kedrosky.

Norwegian Krone and Gold Overlay

I have been advising hedge funds and others about considering a Gold and/or Norwegian Krone position as an overlay for their dollar based portfolios for some time now.  

This isn't a trade etc. per se, it is a multi-year way of protecting purchasing power and expressing less faith in the US Dollar due to an accelerating shift in behavior towards more debt at the federal, state and municipal levels.  The Norwegian Krone overlay portfolio idea appears to be working.

Rolfe Winkler did a nice follow up piece on the Norwegian Krone idea and how it is playing out.   Here are some photos of Oslo.

Black Swan Goggles

So the holiday season is here and you have just received a pair of Black Swan goggles.  These allow you to spot Financial black swans safely from any distance.  Unfortunately  due to the warranty restrictions you aren't allowed to profit from your new super powers.

Now imagine you could also travel back in time with your swanky swan goggles.  What could you do to prevent the crisis?

Think about it.

It is the regulators dilemma in retrospect.  But imagine you are a quant, professor, CEO, banker, legislator etc. 

What role could you play?  How far would you go to prevent the current problems. 

When would you start?  and whom would you need to convince to change behaviour, rules etc.? 

Over $6 Trillion in "wealth" was being "made" by a freight train of "winners" and before that home ownership was slowly seen as a right that all were entitled to via tax breaks, incentives etc.

So who will you be with the stylish shades to change things for the better?

Those advocating better models, or tighter thinking are indirectly posing such a conjecture.  So what would you do and when would you do it? 

If you want you can continue the conversation at the Linkedin BlackSwan Group.

I am a sucker for cool Math: if you hate math, see if you like this video

Great math is beauty in form the same way architecture or painting can be poetry in motion.  Yes it is a bit of syesthasia for me. 

Great communicators are those who illuminate and share new worlds of understanding.  Here is Marcus du Sautoy talking about the history of Symmetry.  The language of math can be incredible and Marcus seems like a great teacher who is excited to share what he sees and understands.

Your world Interface anywhere: The Video

This may seem passe to say, but the rate of change and how you interact with the world is going to change faster than ever.  I am not talking about e-books (next years commodity) killing newspapers etc. or anything that banal.  (don't worry journalism will survive).

The world is going to get more fragmented.  Did you know that your view of the web via google is now different from everyone elses?

Soon your world will not be the same as anyone elses.  I hope this sense of disintegrated reality and individual control doesn't create more selfish people. 

We already control the ambient noise and music, people we choose to interact with/ignore around us etc.  If you work in media you need to be aware of this, partial attention is the pre-cursor to augemented reality.  The hardware for all of this is out there and this stuff is going to be everywhere. 

In the future, people will probably take info: vacations where the seek authenticity and no digital input.  If you feel you are on a digital leash/ addiction with a blackberry, you haven't seen anything yet. 

PS. Apple, microsoft and RIM don't own the moats or competitive edge to be a part of this.  The future is up for grabs.  Google has the strongest position in my mind as they get "infonomics and anthromation.

TED junkie and progress for the Bottom of the Pyramid

There is a great book about growing economies and finding new markets by serving the poor.  It is called the Bottom of the Pyramid.  I read and reviewed it in 2006 and was hooked. 

The thesis is that the poorest people are a huge market and they need services and will pay for them.  People who live on less then $10 a day have needs and they can be served if we listen. 

Here is a great story about the progress of the Aravind Eye clinic, which is an Indian for profit eye clinic modelled on McDonald's.  There is a lot to learn from and consider here.  The gift of sight is delivered efficiently to many who would have never considered it possible.  The ingredients are passion, entrepreneurial management thinking and drive. 

I have a met few people who do this including life insurance for the poor and a specialist in mobile banking.  These are mundane services in the developed world, but can be life changing in other parts of the world.

Full Disclosure: I am a TED video junkie.  I haven't owned a TV in 20 years and am picky about films and shows I watch, but TED almost always makes the cut.  If you want learn something interesting, check out some TED shows.

Creating alternative scenarios is imagination

Thinking about what might be is important for designing better futures.  Here is a stunning visual answer to the question, What if the Earth had rings like Saturn?

Thinking in Prime Numbers

Visualizing relationships, be they mathematical, cultural or physical is a powerful skill.  Here is a great site about an interesting quest for visualizing prime numbers.

 I am a big fan of Phi, the Golden Ratio.  One of the best books on this is Mario Livio's The Golden Ratio.  Livio is a serious mathematician, historian and story teller who brings alive the beauty of seeing how things relate.  The golden ratio shows up in many optimal packing and density solutions involving complex systems, it abounds in nature from the circling of an attacking hawk to the positioning of leaves on stems. 

My guess is we haven't scratched the surface of applied uses for constants like Phi or Feigenbaums constants.  For those interested in how growth and form emerge from nature and complex systems I would suggest studying morphogenesis, starting with the classic On Growth and Form.

All of the above end up relating to and explaining a simple elegant shape such as the a nautilus shell.