Designing better futures

Checklists, hedge funds and human behaviour

Checklists are not sexy, but their results are.  I just finished the Checklist Manifesto by Atul Gawande.  I am sold and you should be as well. Checklists save lives, make money and make life less stressful.

Outperformance seems to be associated with repeat process and efficient group communication. Checklists allow for managing individual and team processes for better outcomes.  The book gives a great overview of how, where and for whom checklists work. How to design and apply a checklist for super-ordinate goals is an emerging science/art.

As a hedge fund guy and anthropologist, I am fascinated.  Checklist dynamics applied correctly could be a hugely important innovation in group dynamics and increasing human potential.  As a tool for facilitating group activity they appear to be incredibly effective.  Read the book to understand how they work.  It involves, group dynamics, social interactions, reducing cognitive load and a host of other things.

Checklists allow for efficiency of semi-structured tasks and better individual and group behaviour goal directed behaviour.  Effective checklists are finely tuned for effectiveness, brevity and looseness.  Looseness is required for creativity to come in.

Great design of a bridge, airplane, product or service comes from the understanding of a goal and the design problems constraints.  Checklists seem to work the same way but in a behavioural real time way.  By providing cognitive, behavioural and group constraints, individuals are freed to contribute more effectively when need be collaboratively. 

The Checklist manifesto is a great book and gripping read.  Converting process into gripping human drama is no easy feat, but this thing reads like an action movie.  My copy of this book is already on loan request to a friend who is a risk manager for multi-billion $ Fund of Funds.  

See and here a check list in action saving lives as Sully lands in the Hudson river and saves lives.  The video is a also described in the book.

Here is Mohnish Prabai's value investor checklist.  He only gives a bit away. 

How Mohnish Pabrai Uses Checklists

View more presentations from MShareS.

I am working on a Charlie Munger type approach to the investing problem.  Charlie preaches inversion as a way to solve problems.  So here is an inversion technique to build a value investing checklist, find some great sounding investments that failed or companies that disappeared from an industry and then list why they failed.   That causal list becomes your checklist.  You can start with firms or experiences that didn't work out.  After collecting data on 30-50 a few patterns should emerge.

Group the failure points or weaknesses into clusters, management, competitive loss, industry type etc.  you could even group according to Porters 5 forces etc.  That becomes your checklist.  Each industry has its own subtleties and the key is to identify the moats in each one and then run checklists around them. 

If you succeed you will end up with a few key rules or heuristics that makes groups able to makes decisions and act, faster, better and safer.  As a hedge fund you might try organizing into teams either by sector/asset class or specialty.  Instead of a beverage analyst, auto, tech etc. how about forensic accounting specialist, emerging threat specialist, regulatory specialist, organizational psychologist to analyze corporate culture etc. to analyze impact for a firm, oh and an anthropologist to capture major cultural trends that may be fading or rising.  This approach is probably cheaper and more effective than trying to find all those skills in one person.

One more note on process and safety: as many other have called for, I wish we had an economic/policy NTSB (national transportation safety board) to do post mortems on accidents.  Ideally the crash board, would have better resources than a university and be independent of industry and congress.  Seeing bubbles after the fact is easy, determining true causation isn't.

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.

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.

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.

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.

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 world discovering the cultural 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.

A nutritious way to learn about economics & politics.

The best way to invest is to arm oneself with information and perspective. Sadly many make the mistake of developing the wrong taste for financial information, preferring junk food to more quality fare.  True financial acumen comes from cultivating a proper palate for economic information.

Being a financial information connoisseur isn’t about being a snob or an effete aesthete as many contemporary observers would have you believe, rather it is about having cultivated a sensibility and taste for only the best information in the appropriate doses and from the appropriate sources, judiciously applied at the right time providing the ability to act uniquely and effectively.

Life is too short and precious to spend consuming the junk food swill that is mostly on offer from CNBC which has qualities associated with an all you can eat Vegas buffet. 

CNBC and FoxBusiness are currently fighting a losing battle to the bottom for TV market share.  The weapons of choice are female eye candy, gaudy graphics and sophomoric shouting matches strongly advocating buying low and selling high.  These tactics endear CNBC and FoxBusiness to neither serious money managers nor the public according to the latest ratings. 

One can only guess that the latest policy initiatives must have the producers rubbing their hands with glee, for without them, there is little to kick and scream about in the world of business. 

Pete and Bob from Nebraska don’t heat up the broker’s phone upon learning that the TED spread has returned to 2004 levels as has recently happened.  They wait for Cramer to hit a buzzer or yell "back up the truck", for that is surely the time for action.

One could argue that real actionable business news and or thoughtful journalism is truly a limited market and that when the current financial storm blows over the ratings and associated networks will wash out with the tide like so much flotsam and jetsam.   

FoxBusiness latest reported viewership was around 21k and CNBC’s was around 250k.  As media business models go this looks like the weak chasing the sickly in a rather sad affair akin two carnies fighting over cigarette butts.

Many investors and money managers are certain that an “edge” is to be had by literally being milliseconds ahead of the competition.  Unless you are a high frequency algorithmic trader or former Flash Trader/thug this is most likely untrue.

Perspective and sound judgment are more important than the latest information hit or tip.  The big money doesn’t move in milliseconds its movements are measured in weeks, months and years. 

One’s information diet should be proportionately adjusted to the task at hand.  An investor ie. someone with a horizon longer than a thinly sliced twitter tip should consider a well rounded diet of information for perspective. 

If you are investing for the next 20 years you may wish to look back over 100 years to understand what is going on, for there is a 1:5 chance you will be up against a 100 year storm.

Many investor diets are sadly deficient in historical, political and international perspective.  Assumptions about equities or debt based on 30 years of history or a single countries returns are hardly akin to an understanding of how political economy or market forces truly work. 

Listening to such people and their homilies is akin to seeking restaurant suggestions from someone who lives on Cheez whiz and Wonderbread sandwiches.  Sadly, most retail brokers and other  financial “professionals” exemplify this condition.

I am not advocating a more robust financial diet to help one predict the market, but rather to avoid panicking or over allocating to it in the first place.  A well fed/read investor acknowledges and appreciates the foolishness of market predictions and other off handed punditry.  They also eschew those who offer such morsels of advice.

The Cash Nexus by Niall Ferguson is a fantastic baseline with which gain to perspective and makes an excellent pairing with Kindelberger’s Mania’s, Panics & Crashes. 

You may not think what happened to the Ottoman or Hapsburg Empires or their debt levels is relevant to you, but it is.  You live and act in a political and economic machine. Its fiscal health could determine your own physical health going forward. 

This political economic machine (country) you live in is mostly similar to others that have gone before it. Over the centuries  the roles of politics, economics, debt, taxes and war are the same, only the actors names have changed. 

Almost every person in every period has thought they were exceptional and unique. History has a way of showing these assumption to be mostly wrong.  Ethnocentrism and an inflated sense of one’s self or one’s cultural period’s importance appears to be a part of the human condition.

Imagine someone claiming to be a biologist who had studied a single specimen for a portion of its life.  Now imagine that specimen was his/her own pet.  That person might be considered to have a rather limited expertise and some narrowly biased opinions.

Most economic journalists are just such persons, who are somewhat aware of 10-25 years of their own economies ups and downs.  This isn’t significant as most real reportage does not require depth of knowledge, merely the reporting of fact. But once journalism slips from reporting into punditry, analysis or debate, one requires a bit of expertise and depth. 

This is where most of today’s video business journalism falls apart.  Serious lack of depth during the commentary is made up for with sophomoric emotional zeal and cheap video effects in an effort to sell more cars, Viagra and hope to the mostly older white male clientele who watch.

My suggestion for those seeking to become investors is to remove the junk video from your diet and replace it with a few carefully selected books or blogs.  As a fellow who hasn’t owned a TV in 20 years here is the book suggestion,The Cash Nexus by Niall Ferguson.

The Cash Nexus is broken into 4 sections covering, “Money and Power in the Modern World 1700-2000”

1. Spending and Taxation
2. Promises to Pay  “i.e.public debt”
3. Economic Politics
4. Global Power

If one is serious about investing, then one should study and understand the game that is economic politics.  Money/economy is a useful collectively shared political fiction, i.e.  a created social convention, not a physical reality or science. 

Studying money/economy  as a cultural behavioural belief system with many historical precedents allows one to see how others have built and lost empires with the tools of politics, central banks, war, taxes and debt.  The Cash Nexus is an excellent introduction and provides deep  sampling of many economic issues, bubbles and behaviors which were all “different this time” to their participants, but strikingly similar in retrospect.

If this book were a wine it would be heavy and complicated, not as dry as an academic paper, but rather robust and hearty, best consumed over a few meals and then revisited from time to time for further appreciation. 

If you wish to become an economic information connoisseur you may find you have to make time by giving up CNBC etc. Most TV information sources are the sommeliers equivalent of a sickeningly sweet White Zinfandel, best suited for clueless relatives, teenagers or unwanted house guests.

A few samples from The Cash Nexus:

Major Western country bond yields from 1700-1999 have averaged 5-6% with one of the more interesting spikes occurring in the early 1970’s.  This includes the US only back to 1804.  The biggest decline in yields since 1700 for the UK was in 1998. Pg  177

Interestingly the relationship between debt markets is more related to politics than economics.  The rise of the Napoleonic empire is quite interesting when seen through the eyes of the French bond market, whether it be the Crimean, Prussian or other wars.  This may seem pedantic, but interesting to know the next time a blaring “war/terror” event hits the news.  The debt investor needs to know the difference between panic as a considered and wise allocation move and “a panic” which could be a buying opportunity in sovereign debts.

Tom Freidman aside, Globalisation is modern in the sense that it has been going on for hundreds of years. 

In 1890 British foreign investment was 9.3% of GNP  a level not surpassed until the 1990’s. On the eve of the first world war 1/4^th of the World’s population 444m people lived under some form of British rule. Pg 278.

Merchandise exports were 27% of GDP in the UK in 1870. Pg 294

The Ottoman Empire got into trouble when debt went from 130% of GNP to 1,500% of GNP leading to Turkish bankruptcy in 1874.  Pg 280.

Current US debt estimated at $11 Trillion (dis-regarding future liabilities) would be about 78% of GNP, serious concern and action is in order but not outright panic.  Getting into the Euro required a governments debt to be below 60% of GDP.  Current global debt is 64% of Gross World Product.

There is a great table on bond risk premiums for (Brazil, Chile, Mexico, Egypt, Japan, Argentina)  on page 284.  The dates range from 1850-1993, the concept of debt and risk isn’t new and neither are global capital flows.

The US was a net creditor from 1914-1918 (9% of GNP) and by some measures represented the peak of international lending and capital outflows.  Pg.288

In terms of globalization and contagion, 1931 saw national defaults by Turkey, China, most of Eastern Europe and all of Latin America. Pg 289

Global Merchandise exports as a function of GDP were 9% in 1913. In 1990 they were 13% of global GDP.  Foreign assets were 18% of world GDP in 1913. Pg 291  This is in contrast to an era in 1997 when 144 countries had capital controls according to the IMF. 

We were so much more global then in some ways.

Net Emigration from the UK between 1881-1890 was 7% of the entire population. 

The decade from 1900-1910 saw US immigration peak at 10% of population a level not matched since. In 1990 it was 2.2% Pg 292-294 The equivalent today would be about 30m people showing up in 10 years.

A great chart showing the UK equity risk premium vs. bonds from 1700-1999 shows it ranging from -5% to 10% with an average of about 1%. Pg 303.

There is a great discussion about the rise of government debt markets in Venice and the Netherlands in the period from 1600-1800 and how this allowed for growth in war and trade. Pg 305-312

The famous South Sea and Mississippi Bubbles and the remarkable story of John Law is briefly introduced.  This is the bubble that suckered Sir Isaac Newton in twice. Pg 312-315.   I wish they would make a movie about this as it is a truly incredible story, something along the lines of Stanley Kubrick’s masterpiece Barry Lyndon(youtube)  would be good.

For those who believe Goldman Sachs owns the treasury, consider the following.

The bank of England was owned by the Whig Party in 1694 and the South Sea company was owned by the Tory party in 1711. That is some great crony capitalism and amazing intrigue. 

In 1720 the South Sea Company offered to take over the Entire UK National Debt.  Pg. 316.  And we think we live in interesting times.  Perhaps America should put all its debt on a credit card and then take a vacation with the air miles earned, or perhaps one of the esteemed political parties would like to take on the national debt, it would provide an interesting degree of accountability.

A brilliant quote from Financial journalist Anatole Kaletsky  in 1999 “The entire US economy has in effect become a sort of gigantic investment fund, borrowing money cheaply from financially unsophisticated foreigners (especially the Japanese) and then reaping the profits for investing it more imaginatively in riskier ventures at home and abroad.”   The 18^th century suggests that a shift in sentiment of foreign investors could have dire consequences.  Pg. 318

A great table showing average global inflation defined as the annual mean of the GDP deflator between 1871-1938 as 0.2-1.2%.  Under Bretton Woods (1946-1970) it was 7.3%. Under floating regimes the global average of inflation from 1974-1990 was 19%. Pg 330.

 This presentation of data as averages is suspect but interesting to me nonetheless.

The book is The Cash Nexus by Niall Ferguson. I don't want to tout the book more but rather the experience that may come from digesting and appreciating it.

On a personal note I consider gold an interesting place for cash allocation right now with a 3 year time horizon and an estimated 2:1 risk reward ratio $600 sell, $1,800 upside.  Gold is a horrible investment as it has a long term negative real yield, but as a hiding place from a weakened dollar it may work well. 

Knowing history means I don’t consider gold as a serious long term investment. Knowing history also means I trust politicians with urgent fiscal problems, a willing market and a printing press even less.

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.

Flaw of Averages a useful book and tool

Sam Savage's latest offering Flaw of Averages is a useful book and set of thought tools he calls mindles.    If you have a PHd in statistics or mathematics, your job or role rarely begins and ends with you.  Often your models will need to be explained to people.   More importantly the places where the models could or would go wrong need to get explained.

The Flaw of Averages provides a great read and introduction to basic concepts in probability and real life situations where things behave in un-intended ways, such as the hidden stories in the "average". 

The book's core strength is the author's fun and helpful voice .  He is the stats teacher you wish you, your kids or co-workers wish you had.

Sam Savage has spent a long time in industry explaining and teaching how statistics and models work across sectors.  His chief skills is as a creator of simple stories and mental models that let managers and regular people understand the value of statistics applied.  Dr. Savage sells powerful "light bulb goes on in the head moments" for a living and sells the tools that let people have those light bulb moments in their own respective domains.

If you want a way to understand something from a new angle or some interesting new thought tools, take a look at the Flaw of Averages.  Quite a few useful examples and free simulations are available at his website. 

Topics covered include:

• Flaw of averages in finance and real estate
• Flaw of averages in supply chain management
• Examples of more successful product launches
• Petroleum (peak oil is hinted at)
• Many other real world applications and examples that would allow managers to share powerful concepts.  If you can't afford a $2k/day stats manager to assess some of your business issues, try a few hours of reading this book.

Disclosure: 10 years ago, I bought one of Sam's modeling tools for excel and over the course of 4 years proceeded to lose it somewhere between living in Dubai, Denmark and Brussels.  I called Sam up explained the situation and he let me pick up an upgrade for minimal cost.  He is not only a great teacher/practitioner but a nice fellow as well.

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

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.

Minsky Moments, Wilmott's Magician and a lack of imagination.

Money is not a physical reality or absolute,  it is a collective social belief tool that works very well.  My anthropology is showing.  Money in large collections reflects trust and faith pooled by a group.

The art of managing risk is currently messed up as it is considered a physical science when in reality it is significantly a social science.  The tools, language and metaphors used to describe risk management are mostly 2nd rate physics and introductory probability.

Paul Wilmott has an excellent example of people thinking in boxes and it involves a simple question about a deck of cards and a magician.  The Original post is here.  The all too scary follow up post is here. 

Willmott's magician is as important if not more important than Taleb's Swan in my opinion.

The disconcerting nature of the Willmott follow up article is that it shows people in roles of risk management woefully lacking even the basic skills that it requires, namely imagination and mental flexibility. 

The risk managers who can't wrap their heads around Willmott's Magicians test seem to have some form of cognitive aphasia which has removed all common sense from them.  In a word, they are so enamored with the "laws" of probability that they forget they live and manage a social resource.  Money is a social phenomenon, gamed individually or collectively constantly by people, not diffusion equations with the appropriate drifts.

If you are interested in risk or understand the reason that human behaviour means that the next minsky moment will arrive as soon as we collectively forget the last one, please read the Wilmott Blog posts and think about the skills in a risk manager. 

If your risk management process is lead by PHD's who don't pass the magician test, please put them in a room or island where they can do little harm or better yet, get them into a math dept. where they can do some good.

I am still advocating the book Since Yesterday first written in 1940 as a great way to understand the thinking, events and cultural process known as the great depression. Spoiler Alert:there was a mini echo depression in 1937 when the "stimulus" of the era disappeared.  Since Yesterday is a very rich read and maps disturbingly well to today.

About that social experiment.  This cartoon sums up the interaction between risk management and people's desire quite nicely from Jesse's cafe Americain.

Here is a link to the original source of the comic Abstruse Goose. Tip o' the cap to Noah Yetter.

Minsky moments won't leave us, we are human after all.  Shakespeare figures, bubbles and greed won't go out of style, they are classics and endimic to the human cultural condition, please find risk managers who understand that better than physics.

Top Marginal Tax rates since 1913 & Great Depression

If the shoots are green what color will the next tax increase be?  This chart data comes from the Daily Dose of Excel Blog.  The US Income Tax was started to pay for the Civil war.  More history here.

Trivia for the day taken from the excellent book "Since Yesterday 1929-1939" by Fredrick L. Allen: 

The top Tax payer in the US in 1936 was William Randolph Hearst.  The #2 tax payer was Mae West with $430k in earnings.  The book is a great read and talks about the culture, fashion, economics and politics of a process known as the Great Depression.  It reads like a newspaper from today which is kind of scary.  Economically we are in 1932-33 as near as I can tell. 

Anyone wanting to understand the unfolding economic and cultural process that was "the depression" may want to read Since Yesterday, it is one of the best books I have read in a quite some time.

Accountability and Attribution Bias in mutual fund returns.

I finished The Fundamental Index by Robert Arnott, Jason C. Hsu & John M. West a few months ago.  It is a useful read  even if one doesn't  agree with the thesis about fundamental indexing. There are interesting points to be made about many aspects of equity behaviors and the profiles that make up the concept of equity returns and risk.

I offer the following chart as interesting example of the outcome of mutual fund returns for the average investor. 

Most investors ranging from hedge fund pros to the average person are subject to buying high and selling low relative to their own investments whether its a Hedge Fund of Funds, or the average person buying a single mutual fund. 

Attribution bias is the human bias of attributing success to oneself and failure to some external source.  Accountability and responsibility are out of fashion these days, but I thought I would submit the following for consideration. The chart below is found in The Fundamental Index.

The Ivy portfolio may be for those who no longer buy, "buy & hold"

Meb Faber has written an interesting book, The Ivy Portfolio about asset allocation,Endowment approaches and asset class risk. 

Mentioning asset allocation in polite conversation is akin to discussing plumbing.  Everyone has an idea of what it is, they understand its importance, but it is a topic best avoided in polite conversation at all cost.

Like plumbing, asset allocation becomes "interesting" only when things get stopped up.  Many investors believe their portfolio flow isn't quite working properly and are looking for a way to fix it.  Plumbers are over-priced, dreary and generally smell like carnies.  Luckily Meb  knows a thing or two about asset allocation, isn't a dreary fellow at all and puts on a good read.  He is sharp and has written a focused book on thinking about an interesting method of Asset allocation. 

One of the most important papers in asset allocation is the seminal work of Brinson, Hood and Beebower determinants of portfolio performance which I read in the Jardin du Luxembourg while temporarily taking up smoking as a grad student in Paris.  It describes the principal determinants driving portfolio returns.  Surprisingly, at the portfolio level, security selection becomes far less important in most instances. (Hint: most managers are bad at security selection so the expected or derived positive contribution variance is de-minimus at the portfolio level) 

The general gist of looking at asset allocation is that in the long run it matters more at the portfolio level which is driving terminal wealth maximization, the end goal.  The dispersion and drivers of portfolio returns are driven more at the asset allocation level, than the security level in the vast majority of portfolios, with the exception of Buffet and a few people who know what they are doing.

Long term Asset allocation involves thinking outside of one's own time and geography.  Looking solely at the US equity market even back to 1871 for a doctored S&P index has come into vogue in the last year. This is bad research and sloppy thinking.  It is akin to looking at a whale and saying it represents all the animals in the ocean. 

Many equity markets have not only declined  greater than 80%, but died all together, the same with bond markets.  History is not kind in the long run to paper assets unless they are still growing in the form of timber.  Be wary of the prognosticator with an imperious tone, sense of history and a sample size of one.

Meb's simple solution to this asset allocation exposure "buy and hold" dilemma is to get out of an asset class when it looks iffy.  The trick of course is defining iffy.  In this case it is a moving average of 200 days.  I am usually against advocating the use of a single moving average or any "technical" as most people don't understand what they do, how they work or most importantly why.  Meb has some good counter arguments for why one could consider this 200 day variable a nearly "naive" or non-optimized approach. 

This 200 day number still an area for further research, which will hopefully be taken up by an econometrician as the drivers of any allocation process should be understood.  It would be interesting to see how the approach fared against the multitudes of examples of bubbles in assets ranging from farmland to tulips over hundreds of years and markets mentioned in Kindleberger's excellent work mania's, panics and crashes.  The inherent question being; is there something in the Hobbesian leviathan of human bubble behaviour that has a shared time element or profile, Karl Popper would of course argue yes.

The Ivy Portfolio shows that across many periods of time and asset classes the risk using this 200 day long/cash approach is reduced and the returns increased for a portfolio using the respective asset classes.  As an allocation exercise Meb provides multiple examples and potential justifiers for why this approach may work. The approach is always long the asset class as indicated by an index (ETF) or flat cash.  More importantly at the portfolio level the allocation is modeled equally across asset classes.  This is important as discussed here,as a priori optimization can be sub-optimal post fact.

The examples in The Ivy Portfolio are shown with Index and suggested ETFs. A website is available showing highlights to the approach.  The Ivy Portfolio is a lot cheaper from a cost perspective than managed mutual funds and provides higher levels of diversification.

There are a few nice additions to the traditional Stock, Bond, Equity assets classes.  One of these is a proxy for managed futures, ie. commodity exposure.  As a former participant in the Chicago pits and teenage futures trader I appreciate these market's efficiencies.  I wrote my master thesis on quant approaches to hedge funds and found the low-correlated positive skew in commodities whether trend following with an MLM type index or passive like the GSCI to be a useful complement to many portfolios.   The passive commodity indeces are over oil weighted, Dollar denominated etc. and did horribly in 2008.  I have exchanged a few e-mails with Jim Rogers about this, he of course recommends the Rogers commodity index.

The naive approach to weighted asset classes and adding commodities was good in The Ivy Portfolio's approach. Most people will realize this in 2-4 years post priori when the current stimulus works its magic on the purchasing power of the US dollar.

Another nice asset class addition mentioned on page 116 is currencies.  Having lived in 8 countries and worked in 6, and sat on a quant currency prop desk in London building index strategies, I am a big fan.  For those interested, Here is a crude Forex product I put together based on some work by Pierre Lequex and Emmanual Accar when I worked on unsuccessfully launching a money market forex product in 1997.  Go figure, everybody wanted the +100% returns of pets.com and co., they weren't interested in 15% returns or a nice cash proxy yielding 200bps over t-bills and no leverage.

Timing counts in fund marketing just like comedy and juggling.  The product had low correlations to traditional assets, it is similar to some Deutsche Bank momentum products available today.

The Ivy Portfolio if nothing else will get you thinking at the portfolio level.  The returns show a risk reward ratio (sharpe) of roughly 2X the S&P 500. And yes the approach was out of equities in most of 2008.  So take a look at Meb's book, as Bill Cosby used to say on Fat Albert, "...If your not careful  you might learn something before its done."

If you really want to get deep into alternatives study for the CAIA(Chartered Alternative Investment Analyst) certification and pick up a copy of Anson's Handbook of Alternative Investments or read Gibson's book on allocation, just don't bring it up at cocktail parties or first dates.

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.

Monty Hall: information & door #1 investing

One of the most famous problems in popular statistics is the monty hall 3 door problem.  Monty presents you with 3 doors.  Behind one random door is a new car and behind the other 2 doors are goats.

Being averse to goats you select a door hoping for a car.  Monty selects a door with a goat.  You are given the option of changing doors or staying with the door you choose first. 

You should change doors as it shifts your odds from 1:3 to 2:3.  Wikipedia solution.

Being an excel geek, I created a spreadsheet tool to simulate the game 1,000 times.  Warning it does have a macro.  Download MontyHall.xls

One of the things I learned in writing up the visual basic was that Monty does 2 layers of information processing before revealing his answer.

This has a lot to do with investing, as perceptions and behaviours while new information reveals itself are some of the biggest factors to success.  

Many firms operate in mature markets with known market shares and similar inputs to their competitors.  So maybe you are looking at 6-10 doors.

The dynamics of earnings margins are more about the competitive environment and or some structural edge to the respective firm.

The largest piece of information missed by "value" investors is competitive dynamics and the direction of the moat relative to them over time. Munger hints at this in his excellent book Poor Charlie's Almanack.

A firm that has a geographic, regulatory, behavioural or structural moats may grow or shrink that moat over time.  As an allocator, having a process to invest and allocate risk/positions is more important than each individual choice. 

The Moat=the Margin=Earnings edge=extra ROE=Equity price appreciation relative to peers.

Take a look at that relationship above and think about it.  This only works for firms in stable competitive dynamics i.e. mature stable industries.  Most technology lead firms have black swans flying at them out of garages in silicon valley everyday and may not be suitable as classic value investments.  It is my belief that Buffett understood microsofts and many technology businesses. I think he just didn't know how they could keep an edge over time.

You have 25 years and can make 1 investment among 3 choices: Coke, Apple or Google?

So how do you figure out what Monty Hall is telling you, skip the goat and get the car?

The car is a high ROE at fair price over time with a moat that expands as the firm grows leading to share price appreciation assuming you bought it at a reasonable value.

This is the proverbial snowball rolling downhill.  Coke in the 1950-90's was like that with a single simple product, and ever better distribution and purchasing power.  Eventually the behavioral moat "taste"triggered by marketing and lemming consumers watching each other guzzle the stuff meant a widening moat.  Also recognize the Mungerian (sic) lalapalooza effect of multiple feedback loops.

• increasing sales lead to better input margins
• increasing sales lead to more efficient advertising buys
• increasing sales lead to more points of presence
• increasing sales lead to more cultural behavioral visual cues triggers other to consume

Monty Hall is the historical margins earned by a firm relative to its peers gleaned from 10Q's and 10K's.  Watch firms with better operational margins or efficiencies.  Understand their moats and substitute products.  As a hedgie, anthropologist with a deep technology background it is fairly easy for me to see behavioral moats and the limited lives of most technology moats.  

Coke as a product will most likely be here with stable margins in 20 years, Abercrombie & Fitch less likely.  The half life of a fashion firm is limited and in its death throes, it will most likely spend any retained earnings away on marketing and other new forms of "coolness" that allowed it capture large margins in the first place.

The "problem" of asset allocation in mature business sectors isn't purely closed form like Buffett & Munger's pari-mutual betting analogies, but in some industries it is close enough that trends seen in expanding ROE over time may be indicative of sustainable advantage.

If one treats the sustainable comparable ROEs as indicator of competitive edge and longevity then there might be an investing edge assuming the price is right. 

It is critical to understand what drives the edge.  If it is a one off or something that doesn't scale with the business then think again.  Monty can be tricky and most likely 2008 was goatish enough.

Where did value investing go wrong in 2008?

One could argue value investing didn't go wrong, the economy did.  Value investing just tagged along with the market.  Value investing isn't market timing or macro analysis per se, it occurs at the security level.  Portfolio exposures at the economic level are another matter.

The diagram above explains why.  The grey circle represents a firm at some fair value operating in a mature competitive dynamic. 

The investor is looking for the car behind door number one over time.  It is important to realize that relative to its peers the firm may well have delivered #1 results, but occasionally the larger economic environment overwhelms that success.  The background represents the ups and downs of the larger economy green is positive and red is negative.  The GDP and credit, normally limited factors in returns loomed large as the acute credit crunch became chronic.

The loose credit from 2004 on created a false economy probably 20% larger than the "real sustainable one" due to the wealth effect of perceived house values and easy credit. 

When the macro economy credit crunch hit a "value" investment, the investment went down like everything else.  Equity appreciation will most likely return faster to those value firms that truly possessed the attributes of value.

A few weeks back a colleague in my office asked, "When do you think the economy will get back to normal", I  replied, "I think it's on its way there now." 

I wasn't trying to be funny. The statement was meant to indicate that spending levels based on false credit meant an economy as measured by GDP that was 10-15% ahead of itself in terms of spending was reverting to its longer term growth rate. 

A contracting real GDP may overshoot the long term growth rate on the downside but will eventually find equilibrium with a better current account balance and savings rate in the years to come.  Yes it will take years.  Fear doesn't dissipate quickly and the greed built up for a long time as shown in the savings rate. 

The major issues now are how the economy ebbs and flows relative to the latest acronym dreamed up in DC.  The new "normal" economy looks more like a big spending program perched dangerously on top of a massive t-bond bubble trading at a fear premium of 3% for 10 yr government bonds. Dollars anyone?

Value investing combined with Kelly betting smarts: The Dhandho Investor by Mhonish Pabrai

Mohnish Pabrai puts forth a quick read for novice and expert value investors in The Dhandho Investor.  Value investing is more than just buying something cheaply, it involves understanding the nature of a business and the markets in which that business operates as well as the intelligent allocation of risk capital at the portfolio level.

Pabrai is a successful investor who understands the major lessons for long term terminal wealth maximization.  He is quick to credit those whom he has learned from and comes across as a helpful and supportive teacher.

Pabrai clearly articulates the keys to value investing for maximum terminal wealth

1. Understand a business and its operating market dynamics, cycles and position
2.  Think about moats as margins that contract or expand overtime or due to catalysts
3. Understand intrinsic value and work back from this figure
4. Come up with a few outcome scenarios and probability weight their likelihoods
5. At the portfolio level focus your portfolio bets according to a fractional Kelly betting/allocation mentality. Only risk a little to gain a lot.  Understanding how and why the odds are stacked against you is the first lesson to overcoming them.
6. Exhibit patience

Many value investors stop at step 4 and never contemplate the nature of change inherent in item2 or the dynamics and importance of item 5 about bet allocation.  Pabrai presents his thoughts clearly on these items.

A few interesting notes in the book include reference to company longevity.  For example companies have finite lives something glossed over in CAPM etc.  Pabrai mentions , the book  The living company by  Arie de Guess and how the average major corporation is shrinking with age as Schumpterian innovation goes into overdrive.  Innovative competitive environments are anti-thetical to value investing as the represent moat uncertainty.

With regards to patience, Pabrai offers an extract from a table of major events seen below. 
It speaks highly to the virtues of patience in light of responding to acute news events which may not be economically chronic. As Portfolio manager and not a trader, he discusses waiting for 1-3 years for ideas to work. Again the anti-thesis of having an emotional Cramer moment a la CNBC.

DJIA declines and subsequent performance after crisis events paper here.  You may be surprised at the resilience in markets after an acute news shock.

 
Pabrai also gives acknowledgment to Joel Greenblatt’s useful book and approach from The little book that beats the market.  Greenblatt's book offers a helpful approach to portfolio design via a basic ranking system.

The Dhandho approach is to risk little in order to gain a lot over a period of time and focus on long term wealth maximization.  Pabrai comes across as level headed and as a person with a significant future ahead of him creating and contributing value in many areas.

Discipline and patience are vital. 

I have found in my research of Mutual and Hedge funds that most investors under perform both the mutual and hedge funds they invest in.  Here is a paper on the phenomenon.  Think about that for a moment, even after the work of selecting a great vehicle, the average investor manages to extract below average returns from that investment vehicle. 

If the average actively managed fund under performs the index by 2% and the investor under performs the fund by 2% and equities return 8% over the long run in real terms.  An individual is left with 4% before taxes which in an active portfolio may be short term capital gains weighted.  If the individual switches often "less than a year" to the next HOT thing they are in trouble.

The stream is swift and you are going up and into it, plan carefully and thoroughly. 

Side note: reading & investing your most important asset (Time):

I haven't owned a TV in 20 years even though I was a former chief analyst for Europe's equivelant to the MIT media lab called STARLAB.  My suggestion, sell or turn off the TV, read a book, excercise or spend time with your friends and  family, these are the sources of real health and wealth.

Quantitative Trading, Ernest P. Chan’s New book is extremely useful

Quantitative Trading, Ernest P. Chan’s New book on trading is extremely useful for Asset allocators, portfolio managers and traders.  They should be doing the same thing, maximizing terminal wealth.

The path and tools choosen varies among the participants. The important thing is to understand what role a person plays and what the processes and tools are for being most effective in that role.

In his book Quantitative trading Ernest P. Chan offers techniques and recipes in Matlab and Excel VBA for the trader wishing to learn more about strategies such as Co-integration, money management, back testing, mean reverting and momentum strategies etc.  Chan has broad experience with tools and techniques for various strategies and explains things clearly with the voice of an experienced practitioner. 

Some of the most important work Chan offers in his book has to do with tying the trade or position level and its potential role in a long term portfolio context.

Many traders and asset managers think in terms of $’s or % of portfolio at risk. Many trade with rules of thumb but may not have studied how to maximize the terminal wealth of their strategies and approaches. 

 
The Sharpe ratio is the standard risk metric that most allocators and analysts use to assess a manager or trading systems performance. The Sharpe ratio is typically shown as the annual rate of return minus the risk free rate divided by the annualized standard deviation. This metric is a simple way to measure risk vs. return.

Many gamblers are familiar with card counting and betting strategies based on the odds of the game they are playing. Years ago a formula was derived called the Kelly formula for optimizing the return on a given strategy over the long run. 

For example, lets say you play a coin toss game that pays you 101% of your bet each times heads comes up and costs you 100% each time tails come up. How much of your “portfolio” should you wager each time to maximize the returns with this game over the long run? The Kelly formula answers that question.  

The transaction pyramid to the right shows the activity levels of various practitioners.  All of them can learn a little thinking about the Kelly and Sharpe Ratio relationship.  Whether gambler or student of high finance, it is one of the keys to terminal wealth maximization.  I recently created a free spreadsheet tool for exploring this relationship based on Chan's work.

Chan comes up with a simple solution for assets allocators wishing to maximize terminal wealth using Sharpe ratios. With any trading system or allocation approach caveat emptor. Investing in fundamentals with a margin of safety that skews the odds in your favor may be a better approach for portfolio managers. 

For the asset allocator converting the Sharpe ratio into a single asset allocation % may be an interesting starting point in allocations, but macroeconomic issues are probably more important than variance assumptions given the time horizons and principal return factors involved. 

The correct application of the Sharpe to Kelly relations is usually to apply a “sub-optimal” allocation to arrive at a margin of safety. Sub-optimal allocations are chosen as portfolio level assumptions of correlation and co-variance are unstable, this is referred to as a fractional Kelly implementation. These days sub-optimal means an increased Cash or a high cash proxy. Please choose your currency carefully, risk free isn't risk free anymore. My bias is for the Norwegian Krone for the next 2-3 years. 

I would highly recommend Chan’s book for the fundamental, technical or quant trader. Chan is concise and clear in teaching the basic methods and tools for a quant. You can visit Chan's excellent blog to get an idea of his thought processes.

For the fundamental portfolio manager, simple factor based analysis may help provide a piece to the puzzle about cyclical influences.  My personal interests are studying inter-market company level competitive dynamics and likely moat variance over time.  This is probably due to my anthropology background.

I consider economics and markets as nothing more than simple group behavior pursuing individual interests.  These groups and individuals are capable of collective myopia and flawed beliefs due to ritualized knowledge and codified social structures.  Watching an economy from the outside like a field researcher can be fascinating and lucrative. 

One just sits and waits for knowledge to ritualized to the point where it isn't questioned and then take the opposite position.  Ritualized knowledge can be in the form of structures such as flawed systems like ratings agencies or Mean Variance risk tools.  False ritualized knowledge can also be in the form of aggregate memes such as house prices can't go down, we are in the 7th inning of the economic storm etc. these narrative become group myopic beliefs leading to blindness and flawed group behaviours.  The chain of logic that generated the meme is collapsed into an oft repeated truism which ultimately proves false.

CNBC is the meme machine of American casino capitalism.  When it goes off air in 6-8 quarters, it  may be time to buy equities again.  The silence will be golden. The ratio of octoboxes and decaboxes to viewers must be sliding. The more CNBC screams and rants the fewer people care to listen.  There is some good stuff on CNBC, but the needles are getting lost in ever more haystack.

Both fundamental and technical trading and allocation approaches have merit when used as part of a long term process. For those interested in applying technical tools to fundamental allocators, check out AlphaClone.

The opportunity to learn yet another approach to asset allocation such as the trading techniques illuminated by Chan, even if not pursued help one think in yet another frame. Cognitive code swithing in linguistics is related to intelligence.  I should like to think multiple analytical framework application is the tool for maximizing terminal wealth at the individual and collective levels.

Dear Mr. Buffet: a book review with a little "extra"

Dear Mr. Buffet, What an Investor Learns 1,269 Miles from Wall Street

Janet Tavakoli is one of the top experts in the fields of structured finance. She is one of the most vocal critics of a system gone horribly wrong and saw disaster looming early on. She even tried to sound the alarm many times with an SEC that in retrospect looks to be on the wrong side of the subpeona issuance business.

The current multi-trillion dollar financial crisis didn’t come about due to any single act of brazen greed or stupidity, rather it was a case of many people all looking for a little extra. Pushing the boundaries at each level has a multiplier effect. Common sense and ethics went out the window as it was all mostly legal and appeared at each level to be just a little “extra” nudge.

Here is my diagram of how each level of the sense of “entitlement” to a little “extra” will cost a generation. The era of rules meant be bent and self-entitlement will haunt the world for years to come.

Actor	Extra	Self deluded Justification
Home Owners	Bedrooms, bathrooms etc.	The neighbors have it, the finance is available and everyone else is doing it. To paraphrase Kindelberger, ”nothing will cause a person to lose their sense of economic rationality than to see the idiot neighbor/relative get rich.”
Realtor/Mortgage broker	Extra income from activity	We are putting people in beautiful dream homes and making a little on the side. Who cares about the loan forms, it’s the loan that counts.
Mortgage “packager” securitizer	Extra yield maybe 0.75% on a few loans via securitization	If the ratings agencies say it is AAA and there is a market for it, then it must be OK.
S&P, Moody’s etc.:ratings Agencies, who have a Government granted monopoly on truth.	Make a little extra income for rating new securitized instruments. An investment grade ratings could increase income by a factor 20x	The models indicate that the loans or OK. We are the original kids who never learned “just say no!” We can model anything and in the face of “free money” or having to say we are ignorant, we will take the money.

 

 One of the problems with securitization as elaborated by Ms. Tavakoli so adroitly is the chain of responsibility and accountability that was broken between lender and borrower. Long term responsibility was packaged up and sold in a heart beat to the next yield hungry bidder looking for a little "extra".  This is a classic agency problem.

Like any drama involving a major loss for an entire generation, this one has many systemic failings. No single actor failed totally, many failed just enough. This multiplied into what is still unfolding as the largest economic crisis in many generations. The reality still hasn’t hit main street America. Wait 6-9 months.

In any group human endeavor some greed, stupidity and laziness will be present. Most cultural institutions and systems are designed to handle these individual components. The crunch was a case of multiple actors giving way just enough to cause a cascading failure.

Ms. Tavakoli uses her letters and relationship with Warren Buffett as an homage to Buffett's ability to distill the basic essence of complex matters into simple facts of money and value. Buffett has the gift of simple language and metaphor to illustrate complex financial truths. He is the Richard Feynman of finance.

Ms. Tavakoli is an expert in the area of the most sophisticated areas of credit derivatives having authored such tomes as Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization. For Dear Mr. Buffet, she has opted for a simple approach to tell the tale of actors gone bad and trust abused at many levels. This book is an accesible popularization of the issues, and as such no heavy securitization math etc. to deal with.  I agree with this approach as the story needs to get out to as many as possible.

It is a tale of oversight and minor characters who loomed large in their time, but will be seen as petty by future generations. Financial debacles and their actors rarely make sweeping historical reads.

The embodiment of the Wall Street tyrant appears to be Dick Fuld, a small man in many ways ,who is the essence of the bully standing in the atop an empty castle with nothing to offer but an angry wimper. Mr. Fuld, Sandy Weill, Stan O’Neill, Angelo Mozillo etc. are the sorry human reflections of a failed culture.

Buffett comes across in classic form as modest and thoughtful in dodging the mess and politely not making too much money from it. His low ball bid for MBIA’s good assets gets scant attention in the book. If the bid had been put forth by anyone else, it would have been seen as good business, but poor taste. Buffet can pull this stuff off and still look saintly.

One small critique I have of the book is Ms. Tavakoli’s light treatment of Buffett in regards to Moody’s rating agency. Buffett talks his book in regards to his holdings in Moody’s, but there needs to be a house cleaning among the entire NRSRO system. My suggestion would be to eliminate it and all SEC mandates referring to ratings. Better no risk system than chasing a flawed one.

Ratings agencies are the pimps of Wall Street, dressing up securities to happily service Bankers and Fund managers too lazy to do their own due diligence. The average fund manger is happy to look for a little yield with minimal effort at due diligence or god forbid independent thought. The coming storm in the Muni-bond market will be eye opening for those managers who buy alphabet soup from the rating agencies and sell "extra" basis points to their investors as performance without knowing what is under the hood of their funds.

The game the ratings agencies play with Municipal bond ratings would make any mafia member’s eyes swell with envy as a protection racket. The ratings agencies are an in-built American systemic failure in a system that causes catastrophic “normal accidents”. The U.S.S.R. had Pravda and we have the NRSRO to separate state truth from fiction for us.

A word of warning about reading this book, it will make you angry. If it doesn’t, read it again until you understand it. The more one understands the nature of what caused this hyper-accident, the more blame there is to go around.

As a hedgie, I studied the bond insurers, attended last year’s asset securitization conference(blow out Super Bowl party sponsored by the US taxpayer) in Vegas and watched the Senate testimony from the front row  given by the likes of MBIA, AMBAC and Moody’s.

A fitting touch at the senate testimony was the happy coincidence that Mr. Spitzer put on his special show as Client #9 only hours before his testimony. We can only be thankful that Mr. Spitzer’s attempts at corning the market on self-righteousness have been doused as his powers of heightened self importance seemed to be getting out of hand.

Mr. Dinallo, the New York insurance superintendant appears to be genuinely trying to making the best of a bad situation. My own opinion is that the bond insurers still have a role to play in the credit debacle as Municipal bonds start defaulting and the insurance they so happily offer is seen to be as valuable as Joe Brown’s piercing insights into MBIA’s own solvency or lack thereof.

Stay tuned, this will play out in the next 6-9 months as municipalities across the country start defaulting and the bond insurers get handed from the State level up to the Feds. Tarp which should be Latin for financial herpes, really is the taxpayer gift that keeps giving.

The story Ms. Tavakoli shares is not a simple one, the actors are all intelligent and each plays their role in inflating the credit bubble. None are innocent and yet all profess to be victims in retrospect. The saying is that success has a thousand fathers and failure is an orphan. The credit bubble that is engulfing the world was a web of greed that reaches down from Government to Wall Street across main street and right to the front door of your neighbors.

Everyone was entitled to bigger homes, free money etc. a few players highlighted in Ms. Tavakoli’s book delivered that little “extra” that now engulfs the world.

Heretics of Finance was my lump of Xmas Coal

  I ate a little too much on Christmas eve and couldn't sleep, so I thought I would read my fresh copy of the Heretics of Finance while I waited for the fat man to make his entrance through our chimney.  By 2:00 AM no Fatman, no gifts and a disappointing book was finished.

Andrew Lo faces a challenge with any book he writes or co-authors. That challenge is the quality of the body of work he has produced before.  He is one of my favorite academics in quant finance as he usually has a healthy skepticism of the efficient market hypothesis and is willing to entertain differing opinions and properly treat the EMH hypothesis correctly as hypothetical.  This is good science and good judgment, he is robust quantitatively and uses good tools and judgement.

The book Heretics of finance is a series of questions posed to some of the ancien regime of technicians.  I anticipated an intriguing insight into robust results of various technical approaches.  What was delivered was a series of interviews rife with confirmation bias, subjective review and sorely misplaced self congratulatory praise for "beating" the academics. 

The practitioners barely seem to articulate what they do or how they do it, much less present a convincing case "it" has been done.  The title Voo-doo market technician may stand tall after reading this book, if it is held up as the heretics defense.

Most technicians use variations on the theme of a filter (low or high) pass from a signals perspective and seek to transform a price signal into a secondary signal with lower variance and a mean that is shifted to the right with lower kurtosis than the original signal. 

Moving averages, RSI etc. and the usual cast of characters make their appearance here.  I have a lot of patience for the tools they use if they provide results, but little sympathies with the depth with which these practitioners seek to understand either how the tools work or why. 

Studying ancient Greek oracles reading chicken entrails teaches one a bit about Greek culture and the standing of the priestly caste, but woefully little about the drivers of history or fortune telling's ability.  The Heretics of finance, serves up the priests, hands covered in entrails, but with little else to speak of other than a knowing pride that technicians aren't academics.

Andrew Lo has written some good things on quant approaches such his work on statistical arbitrage failure and the dispersion failures in august 2007.  This book is disappointing as it neither entertains nor illuminates.  I should have picked a classic for Christmas eve as I scored an own goal with this one and got a big lump of coal for the effort.

P.S. I'm not anti-technician. I created a quant forex index based on a series of filters seperated by E to reduce harmonics years ago.  The approach works, becuase of serial correlation in central bank rate moves. No magic just extracting serial auto-correlation using a series of filters. The document is here. If you are interested in quant approaches or have a qaunt fund looking to work with someone.  Lets talk. I'm up double digits for 2008 with a 1.10 sharpe ratio using L/S equities.

Unsexy soft infrastructure & economic development

One thing taken for granted but crucial for stable economic growth  is equal access and recognition before the law.  Economies are social systems reflecting behaviours bounded by informal and formalized rules. 

Unfortunately most Economists, regulators and Finance types don't get this.  Behaviour or social dynamics are a bit too non-linear to model effectively.  This doesn't limit finance and economic types from applying mean-variance risk models to everything they see.  These same confident people then turn to shock and surprise when things don't work out, but proceed on with the approach all the same. 

A classic example of this is the well meaning but dangerous Myron Scholes (Nobel prize winning economist). He just blew up his second multi-billion dollar hedge fund. Please keep this man away from portfolios.  I would posit that more economic value in the developed world has been destroyed by economists and risk managers using mean variance models than most natural disasters(see report) over the last 10 years.

Sustainable economic development & legal enfranchisement

If one wants to help a developing country, I would recommend studying a few that developed sustainably. One of the more fascinating examples is the United States as described by Hernando de Soto in the 18th & 19th centuries in his book Why Capitalism Triumphed in the West. The lessons about the value of legal access, a functioning bureaucracy, fairish treatment before the law and property rights is profound.  These intangible things were paramount to building the United States and most developed countries.  The soft infrastructure evolved over time from crude or non-existent concepts to become pillars of developed economies. 

 If it were up to me Hernando de Soto would receive a Nobel Prize in Economics.

Without the evolution of soft infrastructure in the form of equal access to land and property rights (minimal corruption required), many countries would not and cannot develop.  My own hope is that more money is spent researching the soft infrastructure of legal enfranchisement and property.  I am a cheap sustainable development type preferring soft infrastructure over hard infrastructure such as externally financed dams and roads etc.  I don't believe in the Jeffrey Sachs & Bono ego gratifiction show that believes sprinkling the World with $150 billion will solve everything.  This is a classic case of a consumptive culture laying its framework onto a problem.  i.e. can't we just shop or buy our way to a solution.

Money applied intelligently is part of  a solution but we still haven't gotten the intelligently part right.  Buying things is easy, getting people to adopt ideas and codified behaviors is difficult.

For the price of one hydroelectric dam or project finance, a lot of legal and economic field research could be applied to understanding, selling and implementing property rights and creating huge amounts of value for the poor. de Soto estimates the payoff from these soft measures in the Trillions of $'s.  For a critique of why the Bono & Sachs give away wastes precious emotional and fiscal development resources, read this excellent book from William Easterly. 

The US is a useful example to learn from in terms of property rights and the economic power that comes from pursuing equality both in making and accessing the law.  Yes, the current economic issues look daunting, but they are minor in the face of a wildly succesful 200 year development experiment which has provided so much for so many.

  In that vein, a report put out by the UN, entitled Making the Law Work for Everyone makes interesting reading.  The report deals to a degree with the distribution of legal rights in various countries.  My guess is that the variance in legal enfranchisement correlates with economic and political stability. 

 Applying a metric of legal enfranchisement into debt risk ratings etc. or international aid policy initiatives could help foster both sustainable economic and human development.

One critique I have of the UN report is the use of the word empowerment.  Social and political power is typically viewed in a zero sum context.  Thus empowerment is not conducive to constructive dialog among parties.  The explicit desire for power instead of participation thus becomes more militant in nature than solution oriented. 

The good thing about using the concept of legal enfranchisement vs. legal empowerment as a conceptual catchphrase is that enfranchinsement provides a long term win for everyone in terms of stable economic growth and fully participatory political environments.

Beat the Market with Ed Thorpe

I have been studying for the CAIA Chartered Alternative Investment Analyst exam coming up.  It is a bit like the CFA but only 2 exams and focuses on alternative investments.  It may be geeky to admit but it is fun stuff.  I used to build trading models as a kid and play with neural networks and t-bond futures in college back in 1990. 

One of the areas that is new for me is Convertible bond arbitrage which is a great way to get back into math a bit.  The strategies and approaches are as I used to be a runner in the 10 year t-note options pit at the CBOT. 

Awhile back I reviewed Fortune's Formula which was all about Gambler's, gangsters and information theory.  It also had great stuff on portfolio allocation and risk which is a subject much like Taxation that few investors think about at their peril.

Successfully growing wealth via compounding returns needs tax deferment and minimal impacts from Siegel's Paradox (the fact that money lost beyond 13% has to work harder to get to break even.)   Risk management and portfolio allocation is sorely un-respected in the field of investing for the long term.  A simple understanding of portfolio auto-correlations and re-balancing approaches can add 100's of basis points to a portfolio at the fund or even asset class level every year.  Of course this mean thinking about 10-20 year horizons.

One of the Gurus of Convertible arbitrage was and is Ed Thorpe who runs a multi-billion dollar fund in New Port Beach, California.  He still publishes and is revered by Nassim Taleb and the Wilmott quantitative finance crowd for his pioneering work.

He published a book in 1965 called Beat the Market that is now out of print.  I found a copy via my grandmother in Iowa of all places and had it scanned.  You won't learn anything new in there, but it is interesting to see a pioneering piece of work and the historical bits such as:

• Spreads of 30-40% on warrants
• A capital gains rate of 25% considered long term after holding a position for 6 months
• Today we call them investment "ideas", back then they were "situations"
• and this view of the future: "We are misguided  when we exalt ourselves by insisting that the psychology of the marketplace and of man are unknowable.  The sciences of man are now emerging from the Dark Ages.  Economics and psychology stand today at Koestler's watershed just as astronomy did in the time of Tycho Brahe.  Our superstition, blind belief, and ignorance are being swept away forever by the scientific accumulation and analysis of data.  There will be predictability in the affairs of men."

Funny how the technology always gets better but the folly and fickleness of men never changes.  Glad a I took anthropology study psychology and sociology in my spare time. That scientific prediction of man is a little over the horizon.

If anybody is interested in a PDF of Thorpe's book Beat the Market for educational purposes drop me a line.

Charlie Munger, heck of an applied anthropologist

Charlie Munger is probably one of the top applied anthropologists out there.  He is very eclectically read and constantly hoovering up knowledge.  My kind of person, probably very fun to chat with at a dinner party...oh and he invests a bit on the side. 

Take a look at a presentation he gave on his study of human biases here.  I still believe that the Munger & Buffet magic has more to do with understanding cognitive group failure than anything else.  Applying discipline and risk control are a part of it as well, but basically sitting back, connecting a few dots and seeing where the blindness of crowds has taken over gives a fellow a heck of an advantage. 

Here is a fascinating video of Charlie Munger in action, he is older, but very sharp and I think his ability to grasp disparate information and think laterally is impressive. 

Thanks to Shai Dardashti of Dardashti Capital for pointing it out. 

Munger's mention of Jared Diamond's Guns Germs and Steel should justify reading it for anyone.  For those silly uni dimensional finance types out there, pull your head out of the Wall Street Journal and the increasingly useless Barrons and read some psychology (Cialdini) or sociology.  You want your performance to deviate from the norm, but this can't happen if you behave and inhale the same information as everyone else. 

I also agree with Munger's critique of derivatives and a significant amount of economic mathematics.  It is intellectual masturbation masquerading as science and proving very expensive and dangerous to us all.  The false notions of value and risk management conjured up are serious threats to everyone collectively, not just the egg heads, and I say that as a recovering quantitative analyst.

My final recommendation for those too downbeat about the present.  Pick up a copy of The Singularity is Near, it will alter your view of the future.  And since, I am being so damn preachy, get rid of your Television, I have survived without mine for 15 years and 6 countries.  I don't know who won American Idol last year but I'll get over it.

The singularity gets nearer and we get anxious

 Intel is going to be shipping chips with thousands of cores in the near future.  You can now purchase a graphics card that performs a teraflop (1 trillion calculations per second) for your PC.  Today's breakthrough is tomorrow banal trinket or play thing.

The singularity which is kind of a rapture for geeks is approaching.  The ebb and flow of politics and economics are going to become more driven by technology than we have ever imagined. 

I used to work in an institute designed to discover applied science for 100 years in the future.  I toiled away as Chief analyst for 70 PHd's working to create the technologies in nanoscience, bioscience, artificial intelligence, energy and materials science that would shape the future.  We had 2 noble laureates and Nicholas Negroponte of the MIT media lab on our board.  It was a powerful learning experience about science and applied research with fascinating and brilliant people.

What does all this technology mean?

In my mind, the book that highlights what the technical progress will become most effectively is the singularity by Ray Kurzweil.  Trained as an anthropologist, I can guarantee that how these technologies are applied and used is impossible to predict, but the sheer power and magnitude of change will be overwhelming and culturally transforming.  The singularity is Utopian, I constantly remind people we are only apes with opposable thumbs and the gift of language.  To fully appreciate this read The Third Chimpanzee by Jared Diamond author of Guns, Germs and Steel.

The great science fiction writer William Gibson once said the future is already here, it just arrives in different places at different times.  If you have ever experienced telepresence in a halo room or felt in awe watching the graphics in the latest video game or some new technical breakthrough, expect to have the sensation more often as the future starts showing up in more places in your life.

Change is one thing that seems universally loathed by all cultures and people in general.  We are creatures of habit and social caste, the rate of change which is now taking place will drive many further into thier core ethnocentric beliefs.  I anticipate the pursuit of greater ethnocentric ideals within many cultures as the pace of change accelerates.  This is not necessarily a good thing.  This could mean greater chances for misunderstanding and conflict among self identified groups.  Let's hope the anxiety induced by rapid change is overcome by a sense a shared humanity.  The record among groups of third chimpanzee's for this is not great.

Einhorn's hedge fund highlights the symptoms...

David Einhorn's book is an interesting introduction into the birth and life of a successful fund.  Greenlight Capital doesn't trade so much as it invests in a thesis and is willing to take a longer term approach, a refreshing approach similar to my day job.

Einhorn's book is really a tale about managers, money and how things are wrong in so many parts of the industry.  His book is most interesting for providing looks at the symptoms of a diseased system. 

Einhorn tells the tale of someone trying to do the right thing and making a buck at the same time.  His agenda and motives are clear.

Einhorn digs deeps like an investigative reporter cross bred with a forensic accountant.  He discovers fraud and acts on it.  The response to his actions from many institutions designed to engender faith in the American financial system are deeply disconcerting. 

Caveat, I have only read Einhorn's book and so make these statements with limited knowledge.

The failing institutions include:

• SEC
• Wall Street Journal and many business journalists
• SBA (small business administration which throws your tax money away)
• NYSE (New York Stock Exchange, which is appears to be mostly a pimp for paper profits)
• Mr. Spitzer's term as NY attorney general (which did some good, but was also a dangerous one man ego trip)

These failures appear to be symptoms of a disease of apathy and the lowering of ethical standards at the institutions that are designed to protect the integrity and thus the growth of financial markets and our economy.  The sheriffs are asleep and corruption is seeping in, even worse people don't care or believe anymore.

WIIFM rules.

WIIFM (pronounced wifm) is a powerful acronym taught to me by a friend named Gina Budde.  WIIFM stands for What is in it for me.  This is psychology 101.  No news, self interest dominates behavior of individuals and groups, it always has and always will.  Rarely does someone steps outside of a WIIFM mentality to "do the right thing".  As I tell friends, ethics don't count until they cost.  Talk is cheap.

Unfortunately Einhorn's motivation of making money and uncovering the truth is seen to be mistrusted by the very operators who are supposed to uphold the integrity of the markets.  Journalists, regulators and government officials decide it is easier to go with the flow than to do the right thing.  Accuse the accuser becomes an all too frequent episode in these pages.

:WIIFM over Ethics

Independent actors behaving fraudulently to increase their own WIIFM's is nothing new.  What is highlighted clearly in this book is that many institutions by failing to uphold their intended charters fail to make ethics easy.  In successful economies and cultures doing the right thing and WIIFM align by design.  This is the basis for a stable growing economic and cultural system, think whistle blower laws. 

When institutions fail ethically and rot from inside, markets eventually become less efficient and we all lose.  Einhorn's book is less interesting for the story itself.  The roles of rogue, thief and sad bureaucrat have been around since Sumerian's started recording grain shipments on clay tablets.  The roles are  the same only the names change. I am an anthropologist first and foremost.

What is most interesting in the book is the picture of the sorry state of our "soft" cultural institutions.  It is my belief that "soft" cultural assets such as trust, integrity and belief in cultural institutions and pursuit of truth are what drive long term economic stability and growth.  They are leading indicators.  Ethics only count when they cost, and the prevailing attitude among some of America's most important cultural, government and financial institutions appears to be WIIFM.

This scatterplot below sums up why Americans should be concerned about the symptoms highlighted in Einhorns book.  Slipping institutional integrity could be a negative leading economic indicator.  Click on the image to see the raw data from nationmaster.com

Asset allocation (Fortune's Formula) book review & tool

Occasionally one comes across a book that is educational, historical, about economics and that could be made into a movie.  Fortune’s Formula by William Poundstone is just such a book.

Fortune’s Formula by William Poundstone combines Claude Shannon's information theory with gamblers, hedge funds, card counters, crooks and history. 

What a lot of investors and fund managers don’t realize is that they are gambling blindly.  I won’t go into my issues with mean-variance asset allocation, but suffice it to say, I consider mean variance approaches and VaR as belief systems that are far too popular for our own systemic good.

Fortune's Formula includes great bios of Claude Shannon and Ed Thorpe and an introduction to something known as the Kelly Formula.  Ed Thorpe is a mathematician, hedge fund practitioner and in the eyes of some, including Nasim Taleb the rightful co-creater of what is now known as the Black Scholes formula or the (Thorpe-Bachelier) theorem. See Wilmott

Those of you familiar with LTCM are now thinking, “…an academic mathematician hedge fund manager, this is going to have a nasty punch line at the end of it.”  The punch line in this case is thankfully flat and deeply impressive, Billions of dollars managed in one of the lowest variance profiles for decades.  Thorpe has delivered the best financials met by a very small handful of managers.

Kelly’s Formula

Kelly is described as:

“…working at the esteemed Bell Labs, a chain smoker, liberal drinker, a lot of fun, the life of the party. He was gregarious loud, and funny, quick to loosen his tie and kick off his shoes.”

He was also brilliant.  He came up with the optimal “bet” asset allocation strategy assuming one knows the odds of playing the game and the payoff.  His approach to asset allocation provides the maximum return over a given set of time.

Please re-read the last sentence if it didn’t impact you enough.

The basic formula is:  Edge/odds=portfolio allocation (bet size) …what the heck does that mean and how does one use it?  If you are a gambler it clicks immediately, if you are trader or mathematician, have patience.  For those familiar with Markowitz asset allocation there is a nice section on Kelly vs. Markowitz.  I personally consider Markowitz a version of trend following and dangerously suspect in regards to the instability of correlation drift.

The basic premise of Kelly allocation is that in order to maximize the geometric return of a series of bets over time, one should go about allocating capital based on the average edge one has in “winning” versus the odds of winning that are paid out.

The greater your perceived information edge, the more you should concentrate your bet.  There are many Kelly sites and tools, some of dubious merit and intent. For those of you in the money management business, you may want to “tone down” the geometric return and perform a variance analysis relative to the risk profile of investors you have holding your fund.

Simple rules of thumb may be good sanity checks. Having grown up in Iowa and “played” futures as a teen, I can say don’t ever bet the farm on a sure thing, don't worry we still have the farm back there.  As a young runner, I used to watch smart traders managing there bets like this in the 10 year bond options pit at the Chicago Board of Trade.

Investing is a marathon event. Long tortoise, short hare. Investment clients may say they want the highest return possible, most wouldn’t stick around after the drawdown associated with a higher volatility approach even if they wanted to be “part of the plan” in the early days.  The pros, Fund of Funds etc. usually say they are comfortable with a certain volatility profile, but will bolt at certain drawdown levels.

True fact: most investors under perform their investment vehicles.  I have studied this using both hedge and mutual fund flow data. Investors, invest high and exit low.  In gamblers parlance, they make horrible jockeys and can be their own worst enemies.

A simple tool is provided for playing with the concept at the bottom of the post, I just lifted it off the web so make no endorsements for it or anything related to it.  This approach might make sense for a portfolio of investment, drug candidates, product launches etc., just beware of your own biases inherent in the estimates.  Like all models it recycles all too efficiently: put garbage in and you will get garbage out.

The nice thing about investing buy and hold in equities, is that unlike a casino, the odds are actually in your favor over time, assuming your horizon is great enough to overcome transaction costs. 

As a money manager I find this ties in nicely with Buffet’s approach of a few eggs in a basket watched closely.  The greater your information edge (remember to be humble) the greater your holding concentration should be.

To learn more I would highly recommend buying the book, the story is a heck of a read.  If there is a movie it will probably be horrible.

Even Warren Buffet makes an entrance into the book with his passing interest in nontransitive dice.    Warren is all Midwestern style, he speaks plainly, seems to listen a lot and gets results without a lot of fuss, still waters running deeply.

Derivatives: for good and evil

Ok, just winding you up with the title there.  Derivatives aren't good or evil, they are powerful.  I just completed 2 books that touched on derivatives this weekend.

George Soros; The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means

is a very interesting read.  His thesis on reflexivity is always fun.  I will comment on two core components of his thesis, but am not sure I appreciate them fully, so feel free to chime in with comments.

1. Falsifiability, in the Popperrian sense means by definition that economics is not a science, merely a pretender.  I would agree with this, due to the fact human actors are participating, the rules are dynamic and reflexive.  Any system that responds not only to outward stimulus, but to its own perception of that stimulus and guesses in the future is inherently non-falsifiable as the presumption of "knowledge" precludes hypothesis.  It reminds me of my social anthropology training.
2. Derivatives are WMD (weapons of mass destruction).  I tend to agree with this quite a bit.  Derivatives themselves have long left the "hedging" risk transfer function and have evolved into gambling instruments.  As zero-sum instruments they aren't in themselves dangerous from a purely economic perspective.  I do believe however that from a risk concentration perspective failed netting in CDS could lead to a massive multi-bank failure.  The recursive nature of settlement failure in financial networks combined with CDS's sometimes fuzzy notion of EOD and settlements is a cause for concern.  Centralized effective netting is a start to resolution, but needs to be put in place faster than is currently happening.  These conditions when combined with the fact that many reference credits are over-written relative their value and may in fact be netting participants themselves is great cause for concern.  The financial system is a belief system and will face challenges in the light of a major netting counter-party failure.  Let's hope the appropriate central bank steps in as a back stop at the right time.  It worked for Bear Stearns (a non-CDS) related issue, but that was a relatively minor problem.  The CDS concentrations of settlement risk is becoming less of a vague risk and more a statistical inevitability.

Traders, Guns and Money

Mr. Das, funny and thank fully un-politically correct look at the world of bankers and derivatives is an excellent view of the world through the eyes of someone with 25 years of experience a keen wit and a sharp pen.  The veneer that is put on the overly compensated, overly dressed and dangerously unaware participants in the OTC derivatives market is very refreshing.  It is nice to have the pretensions dropped by an insider.  Everyone is in it for the money and those with the most information win.  Customers are sheep for slaughter and traders use banks as either a veneer of legitimacy or the patina of patriarchal legitimacy.  At the end Mr. Das calls BS when he sees it, which is pretty nice and makes for an informative read. 

My only critique of the book is its audience level stretches too broadly.  At one point Variable Basis Points are discussed and in the next instance basic bond calculations are mentioned.  I think a good editor might have separated the specialist and the non-specialist bits.  The humour and trader anecdotes are very true to form and dealbreaker worthy. 

Deviant characters, history and Simon Schama

Deviant behaviour is what makes history.  Most people think of deviance in the negative, but deviance is by definition anything outside of the norm. 

As the anthropologist Margaret Meade said,

"A small group of thoughtful people could change the world. Indeed, it's the only thing that ever has."

In that vein Simon Schama a brilliant Historian delivers the goods and the people that shaped great events. 

My wife and I don't own a TV (sorry we are heretics, have been for years), we do watch DVD's on a projection screen and have spent hours watching Schama explain British History and Art History.  This post is nothing more than a plug for a brilliant set of DVD's and education about the deviant people who shaped the history of art, England and the world.

If you like happy go lucky history watch some Ken Burns, if you like someone who will dish the dirt and make it personal, then Schama is your man.  The BBC is really at the top of its game in these productions.

spy toys: Helicopter in a tube.

I recently bought Mercedes a copy of Spy Wars a great book about the CIA counter intelligence efforts during the cold war.  Never under estimate the Russians, which probably holds true today as well.  Here is some real spy gear that never made it to the field.  Read more about it here at new Launches

Good interior design book

Spotted a nice book while out with my wife Mercedes this weekend.  Interior Design Inspirations (Inspiration Books) makes a nice gift for our friends who are buying a new house. Daab is Euro cool series of interior books. 

Europeans, Finns and Japanese still generally do the best design work in the world, something about the culture I guess.

Martha Stewart (reall named Helen Kostyra) and Ralph Lauren (really name Lifshitz) are close but not quite up to the real deal.

For other great books check out Taschen which is a world unto itself.

As always a trip to Core77 or MoCo Loco can be a treat.

James bond trivia for the day

On the 100th anniversary of Ian Flemings birth with a tip O' the trivia hat to the Economist.  Ian Fleming the author the Bond Series also wrote Chitty Chitty Bang Bang.

Scary financial stuff

demon of our own design is an interesting look at the world of financial risk.

The Author is a practitioner and academic who provides a welcome perspective on the area of contemporary finance and the environment of financial risk. 
The book is a bit heavy going for the lay person who may not be comfortable with options and and basis points, but for the market practitioner it is a must read.

The author put forth a very reasonable account of the foibles and mistakes that have been made in recent areas of finance.  He articulates the theory of Normal Accidents and how they relate to finance in a great way.  Normal accidents, are a phenomenon of design whereby a complex system, be it a nuclear reactors, airplane safety procedures or any complex system is designed to fail.  This design for failure of course isn't intentional but unfortunately due to complexity of interaction the system fails in an un-intended but wholly preventable way, 3 mile island, Chernobyl and about any financial accident you can think of falls within this group.

The author does a good job of explaining why there really is no such thing as a hedge fund and also posits a few interesting questions about the half life of a trading strategy and the usefulness of ever more esoteric instruments.  As he states, just because you can swap out a cash flow based on a state variable doesn't mean you should.

The clarity, candor and perspective in this book are refreshing.  My own personal concerns in terms of financial risk were only re-enforced.  The current credit crunch articulated in this blog will grow in size significantly but most likely not pose any systemic threat on a global basis. 

The current credit issue will be acute not chronic a $2-4 trillion mess at most.  Looming in 3-5 years will be a crisis which will ultimately be attributed to the Basel II capital accords.  This will be chronic and most likely caused by the safety mechanism of the Capital accords which are being put into place to mitigate risk. 
My sincere hope is that more people read this book and think about the dangers inherent in layering on ever more esoteric risk management systems with finer models thus allowing ever greater financial "innovation".  Gamma risk will look like nothing compared to Basel II model risk when it is fully realized.  Innovation is rarely a good thing in finance and banking especially when it involves ever more esoteric ways of "deriving" value by seperating an asset from the fundamental information or sources of it value creation.

Genetics demystified

I am now an associate with an investment fund and thought I would brush up my knowledge.  I am focusing on technology, Clean tech and genetics.  Our fund is a classic value player, we buy $1 bills for $0.30 or $0.50.

I bought the book genetics demystified to see how my knowledge was holding up.  The book has a lot of typos. I should know a lot about this  I am sloppy this way as well.  By and large genetics demystified does a fairly good job of introducing the basics of genetics, genetic related diseases, cancers and the basics of genetic technology. 
Each chapter has a quiz at the end and their is even a final.  I read 2-3 books a week on the train and this was a pretty fun one. 

If you want a primer on genetics get genetics demystified, it covers a lot of ground fairly quickly and accurately.  Just make sure you read carefully there are a few typos and some of the Quiz answers are wrong or transposed.

The US balance sheet and market panic

The global markets are all excited about Sub Prime mortgages, this is mostly a bank event and shouldn't concern main street.  It may offer a great opportunity for value investors :)

An interesting way of looking at the US financial condition is to look at the whole countries balance sheet. Ken Fisher does this and produced one in his book 3 questions that matter.  I am reproducing his work here.

Now most people can't relate to numbers measured in billions, so I have reproduced the balance sheet for the average American citizen, by dividing by 300 million.  The numbers may appear larger than your used to as there is an income skew, thus making the average different from median.  All the same check out the "average" american's balance sheet here: As you can see things aren't really "End of the world" headline making.  There are some bad issues with American mortagages and some serious issues with people taking out loans that are 5-8 times greater than their combined incomes, but by and large America doesn't have many major problems economically or structurally. 

Newspapers and Journalists need to fill their pages and time slots with action grabbing headlines, this means 98% of financial reporting is less than news worthy.  Occasionaly someone creates real insite or something interesting happens.  The most interesting thing about the most recent volatility is the Fed move.  It will be interesting to see what happens in the next few weeks.  My bet is on continued volatility (reverting back to 10 year mean), but not much net directional change (+/- 10%) after the dust settles.  This activity will be choppy and horrendous for hedge funds that were short vol or used barrier options as insurance, as they will get whipsawed.  These same hedge funds will face the indignity of customer redemptions etc.  This is all good news for traditional value investors, who may view this as a buying opportunity.  I am still bearish U.S. dollars vs. the Euro but it is a structural bet on lower U.S. rates and shift in the EURO being seen as a more serious reserve currency.  It will be interesting to see how the ECB handles the next few weeks as it is a real choppiness test of political and fiscal nerves.  The source file for the U.S. and per capita spreadsheets are hereDownload us_balance_sheet.xls . and are a creative commons "attribution licence"

inside the house of money: global macro hedge funds

Inside the house of money is a book about Global Macro hedge funds.  

I wrote my MBA thesis on a quant approach to trading for hedge funds.  I started investing in silver at 10, stocks at 13 and japanese yen futures at 17.  This book was great. Warning, this is not everyone's cup of tea. 

I sat riveted reading about what happened as various people responded to the British pound falling out of the ERM or the Asian contagion of 97 followed by LTCM and Russian issues in 1998.  This is a great book, if you are into global macro events and markets.  I was  pleased and surprised that a significant number of global macro hedge fund managers read the Economist.  It has been my favorite magazine for 18 years. Jim Rogers, former co-manager of the Quantum fund is like an anthropologist crossed with an opportunistic economist, very cool.

If you invest actively, you might want to think a bit like a global macro manager.  If you own a house you are long dollars, long the US housing market and short long term US interest rates.  An interesting thing is that the past 3-4 years in volatility are the exception to the rule.  Current markets are showing the reversion to the historical mean. 

Quite a few of the traders in this book mention wanting to be long Gamma.  If you know what that means you should read this book, it is a fantastic read about an industry which is currently shaking out the amateurs.  By the way in global macro hedge funds, amateurs can manage billions and have nobel prizes, but still blow up.   A PHD doesn't always mean you are smart.  I used to manage over 70 of them, some were geniuses, others less so. If you are picking a fund manager, look for humility, low leverage and low volatility that isn't just created by selling gamma and volatility.

The Joy of deferred Taxes: picking and grinning

This weekend I read The Essays of Warren Buffett : Lessons for Corporate America (Paperback)

What a great book. My wife was reading it between my readings.  Warren Buffet is considered one of the best investors in the world.  This book is a collection of his thoughts on investing and corporate ethics.  Buffet is smart, funny, honest and sensible, a classic midwesterner.  He has no pretensions, is very plain spoken and matter of fact about things.  Having only read him and never having met him, I bet he is very funny and a great teacher.

His basic investing premise is based on finding good companies at fair value and then holding on for the long term.  his record speaks for itself.  He has limited time for the "action" offered by most investment banks and brokers, he prefers to study hard, invest and let good management take care of the rest.  His essay's and thoughts are a joy to read and accessible to the layman. 

One of the issues he discusses a bit is deferred tax.  Ok are you still there.  Deferred tax is a phrase that ranks with proctologist in terms of making people sit up, take notice and quietly slink away.  If you have any money invested anywhere you should stick this out.  Deferred tax basically means you don't pay taxes on something until later. 
 
Lets imagine you are a brilliant stock picker for 20 years.  Each year you buy and sell making a 10% profit. Of course there is a little tax to pay each year, but you don't worry, you are a good stock trader, picker, psychic etc.  and are beating "the market". You get the fun and excitement of buying and selling and tracking "the market".  We will call you Picker

Imagine you are a good investor and buy and hold and get 10% a year for 20 years as well.  This is the boring approach to investment.  The results are a little more exciting.  We will call you Grinner.

Assuming that Picker and Grinner each has $1,000 to invest gets 10% a year and that Grinner has to pay taxes in the 20th year of investing on his entire profits.  If taxes are 28% how much more money does Grinner have...don't worry I did the math for you.  Grinner takes home an extra $3,312.  Wow!


I built a simple spreadsheet for you to plug in your own numbers to see how this works. Download worksheet.xls

The moral of the story is to pick an investment that you believe in long term and stick with it for as long as it reflects good value.  Hold, hold, hold.  Your mileage may very depending on an IRA etc. 
 

Intelligent Investor

I have been spending my summer weekends catching up with some classic reads.   2 weekends ago while visiting Iowa I read The Intelligent Investor.  This book is a 600 page classic of the Value investing theory put forth by Benjamin Graham and so successfully executed by Warren Buffet.

My good friend Graeme called me up the other day about investing and I explained some things which may be useful for people.  I have decided to blog about them so that others may benefit. 

Many people think of investing as about picking a winning race horse.  It really isn't it, is about understanding the difference between price and value in effort to first protect your purchasing power and hopefully over time to enhance it. 
A lot of people believe that if they are inundated with stock price quotes, they can be better investors.  Nothing could be farther from the truth.  Price moves around like a drunken sailor.  Occasionaly it bumps into value and then moves on.   I am originally from Iowa and like to think slowly and move slower.  This works well investing, horribly in trading.

An investor is someone in for the long haul who is going to stick it out. 

To paraphrase Graham," in the short term the market is a voting machine and in the long term it is a weighing machine." 

Voting is pretty much like popularity, remember how popular dot com shares were in 1999.  Now think long term, a lot of those companies didn't create value (make profits).  The premise of value investing is simple. 

1. Firstly ignore the price of an asset.
2. Calculate its economic value.
3. Now take a look at the price and see if you can buy value at a good price.

This astounding revelation :) that people use when  trying to buy a used car flutters away in the complex matter of acquiring shares and investments.  Stock markets and brokers make money with activity.  You make money by sitting for the long haul and thinking for the long term.  That means buying  quality businesses at  an affordable price.

Here is an example of what most people do when buying a share.  They look for a fast and exciting horse.   Apple computer with its iphone release sounds exciting.  Of course having an exciting product tells us nothing about the value of Apple computer as a company. 

If Apple is trading at $120/ share is that low or high?  Most people look to the charts and see if it looks low or high relative to the past.  If it was trading at $60 is that good? It it was trading at $200 is that better?  The fact is, it doesn't matter what the price was in the past or even today, unless one understands value.   You are buying an economic  asset today that is supposed to generate economic value in the future.  Depending on the economic value produced we can assess a "fair" price for that asset today.

For example if a person is truly a long term investor and they buy shares in an internet company at $100 and the next day those shares trade for $50 how should they feel?

If they truly understand the value of the business and believe in management they should be happy.  They valued an economic asset and it is now half off.  If they wish they can buy more of it.  After all investors buy for the future and acknowledge that price fluctuates in the short term.

"A cynic is a man who knows the price of everything and the value of nothing"  (Oscar Wilde)

A silly investor is the same thing.  They will track price to the millisecond and have no idea of underlying value.  Caveat the situation may be different for a true trader.

Basically an investor is looking for the market to misprice value.  It is like buying a $1 bill for $.50  Here is an example of the returns from doing that.
There is of course a lot of other smart work to be done, but basically understanding value is the important part of the equation.  Price is readily available to anyone.

I would strongly recommend that anyone with more than $5k to invest read the intelligent investor.  It will take most people about 20 hours.  Depending on what you learn from your reading, it may be the best hourly paying job you ever have.  I will be writing a few more articles for the "investor under the finance section of my blog"  I will provide some basic tools highlighting why 95% of you should invest in index mutual funds and the value of sloth (deferred taxes and minimal transaction cost) when it comes to investing.

Great Product Service Design Book: Sketching User Experiences

Sketching User Experiences by Bill Buxton

This is a great book, for anyone involved with innovation, product management, communication of new ideas or product development.

Bill Buxton has put forth some great examples of what a Sketch is how it is a prelude to a prototype and how to "create" the future cheaply for testers and user groups to experience things with in expensive and fast tools.  The idea is to create rapid examples of future good and services to see how well they work. 

As Buxton mentions in the book, fail fast and early, learn fast and early.  Redesigning a product or relaunching one is very expensive.  This is a great read and deals with products and services in their "wholistic" setting.  A new idea exists in a context and that context determines its success or failure.    I would strongly recommend you buy this book or e-mail me and I might just lend you my copy.  I keep only 1 of 10 books I read, but this one I will be holding onto or lending out.

Some fun quotes from the book:

Tell me and I forget, Show me, and I may remember.  Involve me, and I will understand. Confucius

And a personal favorite of mine from an anthropologist:

Never doubt that a small group of thoughtful, committed people can change the world.  Indeed, it is the only thing that ever has.  Margaret Meade

Also from Buxton himself:  Innovation in process trumps innovation in product.  The idea is that corporations that innovate processes or better yet internalize innovation as a process will win hands down over those focused on tweaking a product.

And finally Buxton closes the book with a quote from T.E. Lawrence:

All men dream: but not equally.  Those who dream by night in the dusty recesses of their minds wake in the day to find that it was vanity: but the dreamers of the day are dangerous men, for they may act their dreams with open eyes, to make it possible. 

Buxton's last words are:  May you dream in the day.

This isn't your average designer hand book and if you want to be an above average creator this is a powerful tool. 

A link to one of my own personal dreams