Thursday, May 21, 2015

Hand, The Improbability Principle

I would like to say that if you’ve taken a statistics and probability course you don’t need to read David J. Hand’s The Improbability Principle: Why Coincidences, Miracles, and Rare Events Happen Every Day (Scientific American / Farrar, Straus and Giroux, 2014). But even sophisticated quants often seem not to understand why black swans may not be so uncommon after all.

Hand, emeritus professor of mathematics at Imperial College London, former president of the Royal Statistical Society, and the chief scientific adviser to Winton Capital Management, has written this book for the layman. No complicated equations here, just easy to follow prose.

What Hand calls the Improbability Principle “asserts that extremely improbable events are commonplace. It’s a consequence of a collection of more fundamental laws, which all tie together to lead inevitably and inexorably to the occurrence of such extraordinarily unlikely events. These laws, this principle, tell us that the universe is in fact constructed so that these coincidences are unavoidable: the extraordinarily unlikely must happen; events of vanishingly small probability will occur. The Improbability Principle resolves the apparent contradiction between the sheer unlikeliness of such events, and the fact that they nevertheless keep on happening.” (pp. 11-12)

Braided together to form the Improbability Principle are several laws. First, the law of inevitability, which says that of all possible outcomes, one of them must occur. Second, the law of selection, which says that you can make probabilities as high as you like if you choose after the event. Think of the classic example of a person painting bull’s eyes and targets around arrows shot into the side of a barn. Third, the law of truly large numbers, not to be confused with the law of large numbers. This one says that with a large enough number of opportunities, any outrageous thing is likely to happen. Fourth, the law of the probability lever, according to which a slight change in circumstances can have a huge impact on probabilities. And fifth, the law of near enough, which says that events that are sufficiently similar are regarded as identical.

On the face of it, these five laws may seem a peculiar way to think about highly unlikely events, and those expecting a rigorous argument in their favor will be disappointed. But I think this book serves two functions. It offers the novice an excellent overview of probability and statistics, and it challenges self-satisfied quants to reexamine their assumptions. For instance, it’s common knowledge that the distribution of market fluctuations isn’t normal, but even if one were to substitute the not-so-different Cauchy distribution for a bell curve the probabilities would be staggeringly different. In a normal distribution the probability of a 5-sigma event is 1 in 3.5 million; in a Cauchy distribution it’s 1 in 16. Ten-sigma, 20-sigma, and 30-sigma events in a normal distribution are highly unlikely (a 30-sigma event has a probability of 1 in 2.0 x 10197), but in a Cauchy distribution they happen 1 in 32, 1 in 63, and 1 in 94 times. Fortunately, price fluctuations can’t be captured by a Cauchy distribution, but despite all the work done by statisticians, we still are shocked by market movements that, if price changes followed a normal distribution, are supposed to happen only about once every 100,000 years.

The Improbability Principle explains both how our Hardyesque world works and how we do and, more important, should think about it.

Tuesday, May 19, 2015

Palmer, Smart Money

Bankers have always been an easy target, but during the financial crisis they were vilified. Even as we claw our way back towards some semblance of economic normalcy, the reputation of bankers remains tarnished. One doesn’t have to be an Elizabeth Warren to wonder whether finance is as constructive an enterprise as it should be.

Andrew Palmer, business affairs editor of The Economist, is an optimist, as the subtitle of his recent book Smart Money indicates: How High-Stakes Financial Innovation Is Reshaping Our World—for the Better.

Palmer argues that what really lay behind the 2007-2008 crisis was not “out-of-control financial wizardry” but “the humble mortgage.” In fact, he asks, “Could it be that the real lesson to be drawn from recent financial history is that the industry suffered from too little innovation, not too much?” (p. 65)

There is an illusion of safety about property, and “the most natural place for money to flow is where it feels safest.” But, as a former chief risk officer of HSBC noted, “banks are leveraged and property is leveraged, so there is double leverage,” which in a property crash turns into a double whammy. (p. 73)

Castle Trust, a British mortgage venture, tries to solve this problem of double leverage by sharing out the risks. It “offers a product called a partnership mortgage, in which the firm lends 20 percent of a property’s value but asks for no monthly interest or capital repayments. Instead, when the home owner sells up, he or she has to repay the original loan amount and give Castle Trust a 40 percent share of any house-price gain. Conversely, if prices have gone down, Castle Trust will shoulder a 20 percent share of the losses.” (p. 74) So far new home owners haven’t responded enthusiastically to this offer. Growth in the business has come from people remortgaging, even though here the firm does not share in the downside.

Another way in which innovative finance can make a difference is through social-impact bonds, where private investors fund social programs and are paid back from public funds, with a bonus if targets are met. “The theory is that successful projects ought to translate into savings for the public purse, which can be used to pay investors without any additional public spending.” (p. 80) Prisoner rehabilitation and homelessness are two areas that have been tackled using SIBs.

Palmer explores several other examples of innovative finance—a drug-development megafund, the brainchild of Andrew Lo; a retirement planning tool, SmartNest, designed by Robert Merton; equity crowdfunding; peer-to-peer lending; alternatives to payday lending using big data; prize-linked savings schemes. By the way, ZestFinance has found that “there are slight differences in the payment outcomes of people who type their names differently (that is, between those who use capitals for the initial letters and then lowercase letters, those who write their names out entirely in uppercase, and those who just use lowercase). People who write their names out in capitals for the initial letters and then lowercase turn out to be more creditworthy.” (p. 160) A word to the wise.

Palmer believes that “financial innovation has made enormous contributions to society in the past, and it is primed to do so again. … The balance that regulators have to strike is watchfulness for the risks that can cause real economic damage and tolerance for the ideas that can produce real benefits.” (p. 191)

Thursday, May 14, 2015

Bronson & Merryman, Top Dog

Victor Neiderhoffer recently shared his latest reading list, and on it was a title that caught my fancy—Top Dog: The Science of Winning and Losing by Po Bronson and Ashley Merryman (Twelve / Grand Central Publishing / Hachette, 2013). So, while I wait for review copies of more recent releases, I thought I’d spend some time with this one. I’m glad I did. It’s an intriguing investigation into competitive fire—what it is, and how to get it.

I could probably mine this book for a dozen posts. I could write about novices vs. experts (and why I get really annoyed when someone looks over my shoulder while I’m trying to solve a computer problem), warriors vs. worriers, women on Wall Street, playing to win vs. playing not to lose, positive and negative self-talk, additive and subtractive thinking, testosterone, even ballroom dancers and (something I know a fair amount about) dog handlers. But that would be unfair to the authors. Let me simply introduce a couple of concepts instead.

Most of us improve in competition, for a few competition makes no difference, and some are overwhelmed by competition. Science not only predicts which category you will fall into; it “also shows how people can improve their performance in competition, no matter which of those categories they began in.”

“Success in competition requires taking risks that are normally held back by fear. The first risk is entering the competition itself—choosing to compete. Everyone has his own personal threshold where the benefits of competing outweigh the fears. Those who focus on what they’ll win choose to compete far more. Those who focus on their odds of winning choose to compete far less.” On balance, men fall into the first category, women into the second. “Men tend to be overconfident of their abilities and thus are blind to some of the risk. This gets men into more contests, but it doesn’t necessarily help them win.” (p. 20) Another gender difference: men do better at finite games—those with a beginning and an end; women at infinite games, where “there is no end to the comparisons, only a waxing and waning of competitive intensity.” (p. 21)

To some extent, of course, we are our biology. We have a secondary dopamine clearer, COMT, that prevents the brain from overloading. As it turns out, there are two kinds of COMT—the hardworking and the lazy. “In people of European descent, 50% have a combination of both slow and fast enzymes; 25% have only fast enzymes; and 25% have only slow enzymes.” (p. 57) What kind of COMT you have determines how you handle stress. When you’re stressed, the synapses of the prefrontal cortex are flooded with dopamine. People with fast enzymes, which get rid of the extra dopamine, can handle stress; those with slow enzymes can’t.

Before we pity the people with lazy COMT enzymes, the authors call attention to the downside of having fast enzymes. “When someone is not being stressed … the enzymes clear out too much dopamine.” Under normal conditions, the prefrontal cortex of these people works suboptimally. “They actually need the stress (and the dopamine) to get up to the optimal level of mental functioning. They need stress to function best. Deadlines, competitions, high-stakes tests, et cetera.” (p. 58) Trading would suit these folks. Investing would probably be better for those with slow COMT enzymes. “They have better memories and attention and a higher verbal IQ. They’re superior planners and can better orchestrate complex thought.” (p. 60) Mind you, I don’t know how they would deal with severe market turmoil. Probably quite poorly, unless they are experts in reframing their thinking à la Warren Buffett.

Top Dog is not one of those vapid self-help books. Yes, it offers some suggestions for improving performance in competition, but its real value comes from providing a foundation for understanding competition and how we deal with it. It gives us tools, not a single easy answer.

Sunday, May 10, 2015

John Bogle classics

Two of John C. Bogle’s books on investing have now been designated classics. They have been added to the Wiley Investing Classics series, joining such titles as Lombard Street, The Go-Go Years, Reminiscences of a Stock Operator, and The Alchemy of Finance.

Bogle on Mutual Funds: New Perspectives for the Intelligent Investor was originally published in 1993. Since then, investments in mutual funds as a whole have surged eight-fold, and Vanguard’s fund assets have grown 25-fold. They are now 50% larger than the entire industry was when Bogle wrote this book.

To readers who are familiar with Vanguard’s philosophy, this book may seem, as Bogle himself admits, “old hat.” That is only natural. A book isn’t designated a classic if only a handful of people ever read it. Or, in the case of investing books, if its message never resonated.

Bogle on Mutual Funds had two missions: to steer the individual investor in the right direction and to cajole the mutual fund industry into adopting more investor-friendly policies. On both fronts Bogle has had considerable success, even he would like to see even more reform.

His advice to the investor is pretty straightforward, but his arguments are definitely worth rereading, or reading for the first time. People have the bad habit of throwing money at the market without knowing anything about the basics of investing. So they invest in the wrong things, or at the wrong time, and curse their bad luck. No investor can be called “intelligent” who doesn’t understand the principles Bogle articulates in this book. The investor may still decide to try his hand at outperforming the market, but he should know what he’s up against.

* * *

John Bogle on Investing: The First 50 Years is a collection of addresses Bogle delivered, mainly at investment conferences, along with his 1951 senior thesis (“The Economic Role of the Investment Company”). The book was first published in 2001. It reprises the themes of his first volume—investment strategies for the intelligent investor, taking on the mutual fund industry, and economics and idealism: the Vanguard experiment—and adds a section on personal perspectives.

Bogle wrote some of these pieces in the midst of dot.com bubble. The one he delivered at a conference in April 2000 was titled “Risk and Risk Control in an Era of Confidence (Or Is It Greed?).” As he said, “Even as ‘it is always darkest before the dawn,’ … it may well always be brightest just before evening begins to fall. When reward is at its pinnacle, risk is near at hand.” (p. 47) He went on to delineate the four key elements of investing: reward, risk, time, and cost. Investors, as he explained, can control all but the first.

Throughout the book Bogle elaborates on what he considers his most important contribution to the investing community: “the majesty of simplicity in an empire of parsimony.” I can’t think of a better legacy.

Tuesday, May 5, 2015

Luna & Renninger, Surprise

Type “tilt” or “skew” into the Google search bar and be prepared to be surprised. What happens (if you’re observant) is unexpected.

Tania Luna and Leeann Renninger have written an engaging introduction to an under-researched psychological phenomenon—Surprise: Embrace the Unpredictable and Engineer the Unexpected (Perigree/Penguin, 2015). Part analysis, part self-help, the book is a worthwhile quick read.

Anyone who invests or trades is faced with surprises, both upside and downside. Too much surprise—“brought on by change, uncertainty, and ambiguity”—“triggers anxiety: a vague mixture of fear and dread. It is the sensation of our brains working overtime to predict the future.” (p. 33) And so anxious investors listen to financial forecasters and fortune-tellers, trying to get a peek into the future. They want to reduce the element of surprise.

At the other end of the spectrum lies a lack of surprise, which triggers hypostress, “the near opposite of anxiety, … the stress of understimulation. … It’s boredom.” (p. 33)

We want to be in control, to avoid surprise. And we have more tools to give at least the semblance of control—cell phones, air-conditioners, better models for predicting the weather, big data algorithms to figure out our wants and needs. But change is happening rapidly. “Our future is increasingly unpredictable.” And so we seesaw between anxiety in the face of unpredictability and boredom as we try to get rid of surprise by controlling the future with routines and safety nets.

The authors discuss ways to deal more constructively with surprise. One of my favorites is “cool is the enemy of growth.” Here’s a brief excerpt: “Before age six, kids use the word surprise almost exclusively to describe positive events. As we get older, surprise takes on a more negative connotation. Why? One reason is that surprise makes us vulnerable, and as we get older, we associate vulnerability with embarrassment and shame. We internalize all those moments in which we looked foolish. And we take note of the times we looked pretty darn cool. We like those times. At some point, we decide to avoid feeling foolish and aim for cool instead. That’s when the trouble begins.” (pp. 63-64) Another reason that the most creative people are often described as childlike.

Wednesday, April 29, 2015

Halpern, Bad Paper

What happens to you if you don’t repay your credit card debt and the bank, despite its best efforts to collect, writes you off? In many cases, the bank sells your debt for pennies on the dollar to a hedge fund or a collection agency. And if the new owner of your debt can’t collect? He sells it again. Your debt can go through several hands, each “dirtier” than the one before.

Jake Halpern’s Bad Paper: Chasing Debt from Wall Street to the Underworld (Farrar, Straus and Giroux), which came out last year but which I read only recently, is a page-turning exposé of the Wild West of buying, selling, and collecting debt, most of the practices absolutely legal.

Aaron Siegel and Brandon Wilson, the main characters in Halpern’s story, hail from radically different backgrounds. Siegel was born into lavish wealth, earned an M.B.A., and took a job at HSBC. But then he decided to launch his own fund, focused on distressed consumer debt. “Basically, he was interested in buying up the right to collect unpaid credit-card bills.” Wilson, a former armed robber who had spent ten years in jail, was Siegel’s debt broker, buying and selling portfolios on Siegel’s behalf. He was occasionally also the “fix-it” man.

In this underbelly of the financial world, spreadsheets are stolen and consumers are harassed, sometimes ripped off. The FTC, which had sole jurisdiction over debt collection before the creation of the Consumer Financial Protection Bureau, turned a blind eye to most of the complaints it received.

This past January the New York Department of Financial Services issued its final regulations on debt collection practices for third-party debt collectors and debt buyers. The CFPB is supposed to issue its own set of regulations in the not too distant future. After reading Halpern’s book, you’ll understand the need for regulation.

And you’ll make sure that you pay your credit card bill on time. You never want to deal with the folks in this book. They may not break your kneecaps, but they can make your life miserable.

Monday, April 27, 2015

Bourguignon, The Globalization of Inequality

Inequality not only seems to be an intractable problem, it also seems to be a slippery concept, hard to define with any precision and tricky to measure. Normally we talk about inequality within a national economy, and that’s difficult enough to deal with. But François Bourguignon goes a step further. He is interested in global inequality, “a rather complex combination of inequality between nations and inequality within nations.” (p. 9).

In The Globalization of Inequality (Princeton University Press, 2015), an updated, expanded version of the book that first appeared in French in 2012, “the central question is whether the increase in inequality observed in the United States, in some European countries, and in some emerging countries may be considered the consequence of a globalization process, which, at the same time, has drastically reduced income differences between developed and developing countries. Does diminishing inequality among countries feed rising inequality within nations?” (p. 5) The short answer to the first question is, by and large yes. To the second, not necessarily, if the right kinds of policies are implemented.

Bourguignon carefully wends his way among the definitions of inequality and its multiple, sometimes conflicting measures. For instance, do you normalize to GDP per inhabitant, do you take redistribution into account? Here I am going to ignore these important methodological issues to cut straight to some of the empirical findings.

Over the last two decades a large majority of high-income OECD countries, including the lauded egalitarian Scandinavian countries, have experienced rising income inequality. Among the countries that have seen inequalities in wages and standards of living drop significantly since 1990 are Belgium, Spain, and Italy. In France, inequality decreased steadily until the mid-1990s, reaching a level that was low relative to other developed countries, and has increased since then, but to a much lesser extent.

A large number of developing countries, most notably China, India, Indonesia, and Bangladesh, have seen a rise in inequality between the mid-1980s and the end of the 2000s. The same holds true for some of those countries in Africa that have seen the strongest and steadiest growth—Ghana, Kenya, Nigeria, and the Ivory Coast prior to the 2002 crisis. In Latin America, inequality levels rose significantly in the 1980s and then dropped throughout the 2000s.

Contrary to popular claims, it should be obvious from these statistics that growth in and of itself is not the remedy for inequality.

Globalization has “most likely,” Bourguignon suggests, played a role in increasing inequality in most countries because the main beneficiary of “the globalization of trade and the resulting acceleration in economic growth that has taken place over the last two decades” has been capital. “In developed countries, this evolution has contributed to a greater specialization in goods whose production requires more capital, increasing both its relative scarcity and its remuneration. … [C]apital may also have been the main beneficiary in emerging countries that are exporting labor-intensive manufactured products. As for the majority of developing economies that, despite the globalization process, keep exporting mostly raw materials, whether agricultural or mineral, it is again capital- and large property-owners (sometimes the state) who profited from rising demand and prices for these basic commodities.” (p. 84)

But globalization has not been the only force at work in modifying the distribution of income. Bourguignon also points to the “vertiginous development of communication and information science and technology” (p. 85), which, to cite but a single example, has “made it possible for a single person to manage a huge portfolio, often worth a few billion dollars, and to generate larger profits. This has catapulted a relatively large percentage of traders into the very high income bracket.” (p. 88)

Governments have also had a role to play in the rising inequality within nations. They cut progressive income taxes, arguing that “the marginal tax rates on the highest incomes were practically confiscatory and were discouraging entrepreneurship and investment,” and, in some cases, introduced regressive value added taxes. For instance, in the very first year of the Thatcher government the highest marginal tax rate fell from 83% to 60% while VAT rose from 6% to 15%. And governments began distinguishing, for tax purposes, between income from capital and savings and income from labor. “As the share of income from capital tends to increase as income increases, average tax rates for the very high income brackets ended up actually falling.” (p. 93) At the other end of the scale, helping to level things out a bit, “the percentage of GDP going to social programs has increased in the majority of OECD countries.” (p. 94)

Economic policies, Bourguignon suggests, “are generally justified in the name of two very different principles: efficiency and/or equality. Over the last few decades, it would seem as if the first principle has generally won out over the latter. In the name of economic efficiency, a number of reforms have been undertaken that were intended to improve the competitiveness of national economies…. But these very reforms have often contributed to a rise in inequality, without necessarily having a major effect on efficiency.” Are there policies, the author asks, “that could simultaneously serve to promote equality and efficiency, at both the national and international levels”? (p. 116) Or will there “inevitably be trade-offs between equality and efficiency”? Is it the case that “the simple fact of dividing the cake more equally will shrink the size of the cake, because it will distort the behavior of agents and the operation of markets”? (pp. 129-30)

In the final chapters of his book Bourguignon outlines some policies that can increase efficiency and reduce inequality within individual national economies as well as some that can lead to a global convergence of standards of living and a reduction in poverty. Many of these policies have been bandied about by politicians, but few have been introduced.

This book is written for the layman but is nonetheless intellectually rigorous. It sets out the causes of and some remedies for a problem that urgently needs to be solved if we are to avoid what the book’s title warns again, the globalization of inequality.