Sunday, December 4, 2016

Lewis, The Undoing Project

Assume you’ve never heard of Michael Lewis but you’ve read a slew of books and papers about behavioral finance. You might decide to skip this one, figuring it’s more of the same. Put that cognitive bias aside. The Undoing Project (W. W. Norton) is a moving account of the incredibly productive but eventually fraught friendship of Daniel Kahneman and Amos Tversky.

Michael Lewis, the author of such best sellers as Flash Boys, The Big Short, Moneyball, The Blind Side, and Liar’s Poker, is a consummate storyteller. In many fields algorithms may trump experts, but so far writing is not one of them. We still rely on skilled writers to tell us stories we need and want to hear. The Undoing Project is one of those stories.

Other than their brilliance and their commitment to the defense of Israel, Kahneman and Tversky had little in common. Kahneman was insecure, moody, “like Woody Allen, without the humor.” Yet he was a brilliant teacher and bounced from one enthusiasm to another, trying anything, readily accepting failure, moving on. Tversky was the life of the party, an intellectual magnet who “had a preternatural gift for doing only precisely what he wanted to do. … He didn’t pretend to be interested in whatever others expected him to be interested in—God help anyone who tried to drag him to a museum or a board meeting.”

The intense collaboration between these two men produced work that changed the way we think about decision making, risk taking, predicting, our own inherently flawed rationality. It gave rise, at least in some circles, to a collective self-doubt—doubt that we could make wise investing decisions, for instance. And to more of a reliance on models that may exploit cognitive biases but don’t themselves succumb to them.

Although Lewis describes some of the most important discoveries of Kahneman and Tversky, his book is at heart a poignant drama. Dare I admit I cried at the end?

For those who expect something other than emotion from me, here are some notes that Tversky took on conversations he had with Kahneman in 1972, “early fodder” for their paper on how people make predictions, usually quite badly.

People predict by making up stories
People predict very little and explain everything
People live under uncertainty whether they like it or not
People believe they can tell the future if they work hard enough
People accept any explanation as long as it fits the facts
The handwriting was on the wall, it was just the ink that was
  invisible

People often work hard to obtain information they already have
  And avoid new knowledge
Man is a deterministic device thrown into a probabilistic Universe
In this match, surprises are expected
Everything that has already happened must have been inevitable


Since I had no commitments on Thanksgiving, I spent the day reading The Undoing Project. It was a true feast. We should give thanks for people like Daniel Kahneman, Amos Tversky, and Michael Lewis.

Sunday, November 20, 2016

Price, Investing Through the Looking Glass

Tim Price takes on the financial establishment in Investing Through the Looking Glass: A Rational Guide to Irrational Financial Markets (Harriman House, 2016).

He skewers banks, central banks, economists and financial theorists, fund managers, and the financial media. He also exposes what he considers to be core delusions of the bond and stock markets: that “bonds are safe assets that rightly form the cornerstone of long-term savings schemes” and that “the stock market always rises over the long term and is therefore the best place for your savings over the long run.”

The following passage illustrates both how cleverly he writes and where his heart lies.

The downfall of the Western financial system began during an episode of Bonanza. Speaking to the American nation on television on 15 August 1971, interrupting the popular western series in the process, President Nixon announced that the US dollar would "temporarily" no longer be convertible into gold. (The temporary prohibition lasts to this day.)

Price elevates Mises over Keynes, Mandelbrot over Markowitz (who “conjured up a square theory in blissful intellectual isolation and then hammered it into the round hole of the market, with little bits of relevance flying off the theory each time”).

Price is not content to define problems. In the second half of his book he offers solutions. First, he suggests that “value investing is one of the few investment approaches that still makes sense.” He finds Japan particularly attractive, since almost 40% of the Topix stock index trades below one times book value, and over 50% below 1.5 times book value—“Ben Graham’s preferred cut-off demarcating attractively valued businesses from the rest of the market.”

Second, he advocates investing in rules-based, trend-following funds. Trend following “can be like coming in to work for a fortnight and getting your arm broken, every single day. But the rewards can be astonishing.” Of the 11 funds/companies (Berkshire Hathaway was included as a company) that have been in business for an unbroken period of at least 20 years and have generated, on average, over 20% annualized and audited returns, six of them are systematic trend-following funds. Investing in trend-following funds not only holds out the promise of outsize returns but these returns “will likely be delivered with more or less zero correlation to the stock and bond markets.”

Third, gold is “a must-own asset to help ensure the preservation of our purchasing power.” Gold is not, as Keynes suggested, a barbarous relic; “it is the leaders of the world’s central banks that are the barbarous relics here.”

One doesn’t have to agree with Price to appreciate this book. He makes his case in razor-sharp prose.

Wednesday, November 16, 2016

Psarra, 18 Smart Ways to Improve Your Trading

Maria Psarra, who worked on one of London’s biggest prop trade desks and is now a wealth manager, sketches out 18 Smart Ways to Improve Your Trading (ADVFN Books, 2016). These lessons, each between three and four pages in length, were originally published as articles in Master Investor magazine.

Most of the advice isn’t new, although two of the lessons deal with trading the highly leveraged contracts for difference (CFDs). Among other things, Psarra writes about stop losses, protecting profits, position sizing, overtrading, being afraid to pull the trigger, arrogance, and staying flexible.

Psarra’s book won’t replace standard works in the field, but traders looking for nugget-size advice won’t go wrong with 18 Smart Ways to Improve Your Trading.

Sunday, November 13, 2016

Poole, Rethink

Steven Poole is a prolific non-fiction reviewer and the author of such books as Unspeak and Who Touched Base in My Thought Shower?, both dealing with the abuse of language. In Rethink: The Surprising History of New Ideas (Scribner, 2016) he combines writing skill and breadth of knowledge to take an old idea (in its least nuanced form, that there is nothing new under the sun) and rethink it.

Most readers of Rethink will undoubtedly focus on recent discoveries that vindicate long abandoned theories. Mice, it turns out, can inherit a fear of the smell of cherries through epigenetic means. Poor Lamarck. “For the whole of the twentieth century, Lamarck’s name became a kind of ominous joke, a byword for biological theories that were not just mistaken but ridiculous.” And yet, it seems, a kind of Lamarckism is indeed possible. A more stomach-turning example: leeches, those “vampiric slugs,” are frequently used in reattachment operations, skin grafts, and reconstructive plastic surgery; they also relieve symptoms of osteoarthritis when applied to the knees.

Poole gives multiple examples of projects that were set aside or that lost out in the marketplace, such as electric cars or frozen food. Actually, the frozen food case was sadder. In 1626 Francis Bacon, looking at the snow-covered ground from the coach in which he was riding, suddenly had an idea: could meat be preserved with snow? Within minutes he was experimenting, stuffing the carcass of a freshly killed chicken with snow. Apparently, although modern medicine might dispute the account, “he caught such a chill doing this that he died of pneumonia a couple of days later.” The idea of frozen food died with Bacon. It would take 300 years for Clarence Birdseye to unveil his “quick freeze machine.”

Francis Bacon is, of course, best known for his description of the inductive scientific method, which analyzes nature “by proper rejections and exclusions” and, “after a sufficient number of negatives, come[s] to a conclusion on the affirmative instances.” Jochen Runde has repurposed this method for business management. He asks business executives in his courses to think up a novel idea and then think of something that would be devastating to their plan. And then he asks them to do some research on that devastating something. “That’s when they start learning. These hypothetical things are like probes, into unknown space.” Invariably, Runde says, “the stuff they learn starts leading them to modify what they initially had in their business plans.”

So, not only can ideas be rethought, but so can the very process of thinking. For instance, “the sharp line between experiment and theory has been rethought out of existence."

Poole argues for the indispensability of placebo ideas, a view that follows (more or less) from the precepts of Nietzsche and the pragmatists. The person, Poole writes, “who embraces placebo ideas says that the fact that an idea is useful is a reason not to care whether it is true.” It’s a placebo idea, for example, that your vote matters. No major election “has ever been decided by a margin of only two votes. So your vote is literally pointless, and casting it is a placebo ritual. However, if everyone acted on this true belief and declined to vote, then democracy would fall apart.”

Some ideas that died should definitely stay dead. The earth is not flat, contrary to the belief of flat-earthers. Nor are markets efficient. John Quiggin, in his book Zombie Economics, argues that “not only was the efficient-market hypothesis refuted by the global meltdown of 2007-8, … it actually caused it in the first place. The idea ‘justified, and indeed demanded, financial deregulation, the removal of controls on international capital flows, and a massive expansion of the financial sector. These developments ultimately produced the Global Financial Crisis.’”

Rethink is a book that both informs and makes the reader think and rethink (and occasionally argue with the author). It’s even fun—well, leeches aside. I consider that a winning combination.

Sunday, November 6, 2016

Birkenfeld, Lucifer’s Banker

Bradley C. Birkenfeld was, in the words of CNBC, “the most significant financial whistle-blower of all time.” In Lucifer’s Banker: The Untold Story of How I Destroyed Swiss Bank Secrecy (Greenleaf Book Group Press, 2016) Birkenfeld, with the very able assistance of Steven Hartov, tells a harrowing tale, beginning with “All roads that lead to federal prisons are long.”

Birkenfeld got his start in the financial world with summer jobs and eventually a full-time stint at State Street Bank, working for international money managers. Within a year he was handling spot and forward currency trading on 90 institutional accounts with more than $30 billion in assets. He also started keeping track of “squirrelly transactions” and illegal activities at the bank. After he refused to record client calls without their knowledge, a criminal act in Massachusetts, his days at State Street were over. He did not go quietly. Among other things, he took his pile of documentation to FBI headquarters in Boston. The investigation, however, was soon dropped. State Street, he charges, had too many friends in the FBI. And Birkenfeld was blackballed in Boston. Where could “a sharp young banker … make his name and fortune? Why Switzerland, of course.

He started at Credit Suisse for four times what he’d been making at State Street, essentially just to learn the ropes. Once on the “Anglo” desk, he introduced the idea of schmoozing clients and using them to get more clients, a predictably successful endeavor. But he didn’t stay at Credit Suisse for long since his boss moved to Barclays in Geneva and took him along. Once again, he “feted existing clients, proposed more investments, and charmed them into turning over the names of their mega-rich friends.” Barclays, however, started to get nervous. It was 2000, and the Treasury Department and the IRS were targeting tax-evaders. So for a couple of weeks here and there Birkenfeld was sent to London, where tax regulations were lax, to find more rich folks in need of an offshore home for their money.

As Barclays started to divest itself of North American offshore clients, Birkenfeld’s client list was essentially frozen. He got a call one day from a manager at Barclays Bank Bahamas, who wanted to transfer the $200 million account of a real estate tycoon from California, Igor Olenicoff, to Geneva. The problem was that Olenicoff wouldn’t sign the Qualified Intermediary agreement that Barclays demanded. And so Birkenfeld, who had been wooed by UBS, decided to change banks and take Olenicoff’s money with him. With that move and his performance-based bonus (18% of any revenue UBS made from their lofty fees on Olenicoff’s $200 million), Birkenfeld became the highest-paid UBS private banker in Switzerland.

UBS knowingly played fast and loose with U.S. tax laws and Birkenfeld played right along with the bank, living the high life. Then a friend of his found a three-page memo outlining all the activities the bank was warning its employees not to do, “though they were everything we were being paid to do!” Birkenfeld knew who was responsible for this memo, the “bastard Bovay,” who was “like Satan. And what did that make me? A trusting, na├»ve dupe. Nothing more than Lucifer’s fucking banker.”

Birkenfeld could simply have left UBS quietly. But that wasn’t in his genes. He wrote a memo to the head of legal and head of compliance at UBS. No response. Eventually he resigned. And sued UBS to cough up his bonus, a suit he won. But he wasn’t satisfied. He decided to whistle-blow to the U.S. authorities.

To say that the Department of Justice didn’t welcome Birkenfeld with open arms would be a gross understatement. Birkenfeld spends the second half of his book describing his dealings with the American government and railing against some of its leading players. The upshot: Birkenfeld pleaded guilty to conspiring with a U.S. citizen, Olenicoff, to defraud the IRS of $7.2 million in taxes owed on assets hidden in secret accounts and was sentenced to 40 months in prison. While he was in prison, his lawyers worked on his behalf to get a whistle-blower’s award from the IRS. UBS had paid out $780 million, about $200 million to the SEC and $580 to the IRS. Once released, Birkenfeld, still on probation and forbidden from leaving New Hampshire (where he opted to go because it has no state income tax), received a check, with taxes already taken out, for $75,816,958.40!

Birkenfeld was no angel, but one couldn’t help cheering him on as he confronted slimy bankers and vindictive, sometimes corrupt bureaucrats. All in all, a riveting book.

Saturday, November 5, 2016

Updegrove, The Doodlebug War

This weekend, as the American election looms and the market “fear index” has spiked, I’m going to write about two thrillers, one fiction, the other (Lucifer’s Banker) less apocalyptic but unfortunately real.

Andrew Updegrove is back with his third Frank Adversego book, The Doodlebug War: A Tale of Fanatics and Romantics. His second book, The Lafayette Campaign, about hackers shaping a presidential election, was eerily prescient. Let’s hope this one isn’t.

I should note in passing that my review of The Lafayette Campaign wouldn’t qualify me for the political prognosticators hall of fame. I envisaged Donald Trump running as a third party candidate and siphoning votes from the Republican Party. Oh well….

Frank Adversego is a cyber-security expert, this time working madly to protect our massive data storage centers (apparently the largest buildings have over 25 acres of floor space) from annihilation by terrorists. The problem? “The more servers, software, and data you put in a single building, and the more buildings you put near each other, the bigger the target you create. The more everything moves to cloud computing, the more vulnerable we get, especially since the servers that support the Internet and the electrical grid are all hosted in data centers, too.”

The Doodlebug War is a page-turner and, at $0.99, a cheap way to be scared of something other than the outcome of Tuesday’s election.

Thursday, November 3, 2016

Siegel, Predictive Analytics, 2d ed.

When I wrote about the first edition of Eric Siegel’s Predictive Analytic: The Power to Predict Who Will Click, Buy, Lie, or Die, I highlighted the work of John Elder, founder and CEO of Elder Research. He ran a small hedge fund for nearly a decade, but eventually found that “the key measure of system integrity began to decline.” At that time I asked readers to offer ideas on measuring system integrity but was met with deafening silence.

Now, three years later, the revised edition of Siegel’s book has been published (Wiley, 2016). Re-reading it (and it is an engaging, if sometimes repetitive read), I was led to Elder’s 2014 white paper “Evaluate the Validity of Your Discovery with Target Shuffling,” an excerpt from “3 Ways to Test the Accuracy of Your Predictive Models.” Systems traders may find some useful ideas here.