Priorities

Apologies for being MIA the past 2 weeks, been traveling around Europe for a much needed break from school (though I -was- forced to squeeze in a couple of chapters of “Quantitative Methods in Finance” on the trains between cities)

Anyway, as the New Year approaches and resolutions get written, I thought this post from Michael Covel’s blog was pretty good to think about. It was written by “financial heretic” James Montier, whom I personally think makes a lot more sense than a lot of the other Wall Street “analysts” out there:

“We seek to explore one of Adam Smith’s obsessions: what it means to be happy. We also discuss why that’s important to investors, and how we can seek to improve our own levels of happiness. The list below shows our top ten suggestions for improving happiness.

1. Don’t equate happiness with money. People adapt to income shifts relatively quickly, the long lasting benefits are essentially zero.
2. Exercise regularly. Taking regular exercise generates further energy, and stimulates the mind and the body.
3. Have sex (preferably with someone you love). Sex is consistently rated as amongst the highest generators of happiness. So what are you waiting for?
4. Devote time and effort to close relationships. Close relationships require work and effort, but pay vast rewards in terms of happiness.
5. Pause for reflection, meditate on the good things in life. Simple reflection on the good aspects of life helps prevent hedonic adaptation.
6. Seek work that engages your skills, look to enjoy your job. It makes sense to do something you enjoy. This in turn is likely to allow you to flourish at your job, creating a pleasant feedback loop.
7. Give your body the sleep it needs.
8. Don’t pursue happiness for its own sake, enjoy the moment. Faulty perceptions of what makes you happy, may lead to the wrong pursuits. Additionally, activities may become a means to an end, rather than something to be enjoyed, defeating the purpose in the first place.
8. Take control of your life, set yourself achievable goals.
9. Remember to follow all the rules.

That’s What She Said

“That’s What She Said”-worthy quote from my Finance & Economics TA, when he was explaining how to use backward induction to price an exotic option in the multi-period time model:

“If you have these exotic assets, it is better to go from behind..”

Can Europe Save the World?

Attended a debate by the legendary George Soros and Guy Verhofstabt, the former Prime Minister of Belgium. (I like how Soros, a currency trader, needs no introduction, but the former PM of Belgium does)

The topic of the day was “The Financial Crisis: How Europe Can Save the World” – based off Verhofstabt’s new book. I don’t pretend to know much about Europe (actually, I don’t think I know anything about this continent I’ve spent the last 3 months in), but I was there to see the world’s greatest currency trader in person, and I didn’t really care what the topic was.

(Actually, that’s a lie. I attended a video conference talk by Soros a few weeks ago about his theory of “reflexivity”, which was immensely esoteric and hard to follow. So maybe I was hoping that this would be a little more interesting than the last.)

I wasn’t disappointed. While they didn’t say anything new, there were some interesting perspectives from both sides. From what I understood, Verhofstabt was advocating very strongly for a singular European strategy on how to deal with the effects of the crisis. He bemoaned the fact that right now, there are “27 different recovery plans among the European nations”. Furthermore, these 27 plans seemed to be ineffective: according to the IMF, Western Europe would be the only region in the world to remain in stagnation in a few years.

In contrast, Soros called for the implementation of even more regulation on a global scale. He noted that the market fundamentalist approach was evidently unsuccessful: capital flows freely in the current system and cannot be taxed or regulated effectively – it flows to where it is treated best. He looked to the Financial Standards Board (FSB) as a possible solution, perhaps to establish a set of standardized rules which would be accepted and implemented across all nations. This would, according to Soros, prevent “regulatory arbitrage”. Autonomy in terms of enforcing these rules could be left to the individual states.
One interesting point he brought up was that these new rules should apply not only to banks but also to pension funds and insurance funds, since they were all competing for the same capital. This could be one measure of mitigating the contagion effect of a crisis. (I wonder he felt if these rules should apply to hedge funds as well? )

Soros also stated his strong opinions on Credit Default Swaps (CDS). He strongly feels that they should be banned altogether. According to him, a CDS is the equivalent of “selling insurance to people on someone’s life, and then giving them a gun” I thought this was hilarious.

This was honestly one of the most interesting lectures I’ve had at LSE. If only my lectures could be about macroeconomic and regulatory trends, financial crises and their impact, instead of how to price a freakin exotic option.

Carrying the Dollar

So I blogged about my thoughts on the future of the US Dollar a while back.

Three months later, the USD continues its unstoppable decline, showing no signs of stopping. Recently, I’ve observed that the dollar no longer jumps drastically when markets become jittery (and investors pile into safe haven assets) – indicating that the dollar is slowly but surely losing its status as the world’s reserve currency. I think, because of a lack of a good current alternative, that the Yen is now the currency of choice for most people.

The reason for the dollar’s demise? The Fed’s decision to firmly hold on to near-zero interest rates, making the dollar an attractive borrowing asset for a no-brainer carry trade.

A little background: A carry trade is a strategy which involves borrowing an asset with low interest rates and buying an asset with higher yielding rates. If the exchange rate remains unchanged, you earn the interest rate differential in a near-arbitrage. Furthermore, as this is a well known trade, many people do this as well and push up the prices of the high yielding asset – allowing you to profit from being long that asset as well. (Okay, maybe not ALL my finance classes are completely useless).

This is essentially what’s happening in the world: People are borrowing in dollars and using it to purchase commodities such as gold and oil. These assets, priced in dollars, have been trending upward for months – the same time that the dollar has been falling. You can profit from an increase in value, and assets like gold are essentially a hedge against inflation and a falling dollar.

So what’s the conclusion? That the dollar will fall and lose its status as the world’s reserve currency, that inflation will spiral out of control and assets will hit the roof?

It’s not so simple: The Fed is watching inflation like a hawk. The combination of low interest rates, quantitative easing and free liquidity flowing through the world today will most certainly lead to inflation. And when that happens, the Fed will raise rates, possibly in a drastic way. We will then see a possibly sharp reversal of the dollar/commodities carry trade, with the dollar spiking and Treasury/commodity prices falling – nay, crashing – similar to the dollar/yen carry trade of 1998.

I’m not sure when this will happen, but I’m pretty sure that it will. We’ll see where that takes us.

Inefficient Markets

Been reading on the topic of behavioral finance, which is based off the foundation that markets are highly inefficient.

Interesting how everything in modern finance (including like 90% of what I study) is based off the usual no-arbitrage-markets-are-perfectly-efficient-prices-convey-all-information assumptions. Which, as increasingly shown in theory and in empirical evidence, is completely untrue. Kinda makes you wonder about why you’re doing a Masters in Finance and Economics. (Well, I guess if I didn’t do my Masters I wouldn’t have known that whatever I’m studying is completely untrue in the first place)

So what’s the Efficient Markets Hypothesis (EMH)? It assumes that:
1. Investors are rational and value securities for their fundamental values. Hence, security prices incorporate all available information immediately and prices adjust to new levels according to net present values.

2. Even if some investors are not rational, their trades are random and therefore cancel each other out without affecting prices.

3. Even if investors were irrational and that their trades do not cancel out, arbitrageurs will eliminate their influence on market prices, bringing prices to their “true” levels.

Why the EMH would be untrue even in theory
1. Investors aren’t rational, and they don’t follow the usual von Neumann-Mogenstern rationality functions. For example, investors are notoriously loss averse, usually reluctant to sell a losing stock.

2. Individuals systematically violate maxims of probability theory in their predictions of uncertain outcomes. In other words, investors have completely wrong ideas about the states of the world and their true risk. For example, they may extrapolate short past histories of rapid earnings growth of some companies too far into the future and therefore overprice these companies.

3. Investors do not deviate from rationality randomly – they do so in the same way. As a result, buying and selling are highly correlated across investors.

4. Real-world arbitrage is risky – so arbitrageurs would not be as effective as postulated by the EMH. Arbitrageurs face unpredictability in future resale prices, liquidity, and further drawdowns in their marked-to-market portfolios.

Still not convinced? Here are some real world examples of why EMH doesn’t work:

1. Research has shown that stock prices tend to “trend” in the short term (6 – 12 months), hardly in line with the mean-reverting behavior as predicted by EMH. (any surprise why I’d a firm proponent of trend-following?)

2. EMH postulates that stock prices will only react to changes in fundamental values, ie they should move in response to new information. However, many of the 50 largest one day stock price movements in the US since WWII came on days of no major economic news – including Black Monday (19 October 1987) when the Dow Jones Industrial Average fell by 22.6 percent – without any apparent news.

3. Orange juice is produced in a concentrated region, so the price of OJ futures should be largely affected by supply-side factors like weather. However, the evidence shows that weather only accounts for a small portion of OJ prices.

4. The stock price of a company usually rises once it is included in the S&P 500 index. This inclusion is a purely mechanical process, and does not affect the fundamental earnings of the underlying company. Yet, mere inclusion into the index seems to boost the stock price, contrary to EMH which states that the price should only be affected by the NPV of its future earnings.

Markets aren’t efficient. And people who invest based on this belief are fooling themselves.

Unemployment!

In a word: WOW.

I guess I should be grateful I have a job.

What I Learnt From Superfreakonomics

Recently went for a lecture by Steven Levitt and Stephen Dubner, authors of Freakonomics and Superfreakonomics, the latter of which I’ve just finished reading.

Firstly, a little bit of context: Freakonomics was the one book that convinced me that I should be an Economics major. (Sad, I know.) In his first book, Levitt investigated weird and taboo issues using economic tools: data, models, regression analysis, correlation and causality, etc. Using economic lenses to look at difficult issues such as abortion, prostitution, etc strips away the morals of the situation and focuses on the sometimes surprising underlying causes. In Levitt’s words, “being moral isn’t bad, but it gets in the way of answering questions.”

Sadly though, I was a little disappointed by his lecture. Aside from getting my copy of Superfreakonomics signed by the authors (whoohoo!), I didn’t take away as much as I did when Levitt came to speak at Penn. (I think it was, in part, because of the inane boring questions asked by the LSE audience, which had as much quirkiness as my Financial Econometrics textbook)

Some points raised by Levitt:

Macroeconomics, often the public persona of the Economics discipline, is way too demanding and complex to be useful. Economists specializing in it often get caught up in the mathematics of the discipline to be able to provide any useful information. (Sounds a LOT like my Financial Economics class). Thankfully though, there seems to me a movement away from this in academic circles to something more descriptive.

Microeconomics, however, is much easier to understand. We intuitively understand our own individual behavior, and hence it’s easier to come up with models that would generally describe how a rational individual would behave. (However, this doesn’t mean that everyone would behave rationally) With an idea of individual behavior, it’s a natural step to aggregate behaviors in order to get an idea of how an economy might run.

I disagree slightly with that last point. In the words of Tommy Lee Jones in the first Men in Black movie: “A person is smart. People are dumb, panicky, (and) stupid.” Or conversely, James Surowieki would claim in The Wisdom of Crowds that a crowd is a lot more intelligent than the sum of its parts.

Sorry, I digress – let’s talk about the book.
Superfreakonomics, while raising some interesting perspectives on prostitutes, politicians, drunk driving vs drunk walking, and climate change, didn’t blow me away as much as the first book did. A few gems within it are worth mentioning:

1) Levitt describes a counterterrorist agent who built an algorithm to identify potential terrorists by finding patterns in their banking behavior – withdrawals, deposits, and yes – purchases of life insurance. It proved to be really effective too. Out of the millions of accounts the bank had, the algorithm zeroed in on less than 50 suspicious accounts. That’s helluva accurate for that huge a scale. And I thought algorithmic trading was hard.

2) Before germ theory was discovered, there was a suspicious pattern of high mortality rates among women in labor who were treated by doctors. The cause? Doctors weren’t washing their hands.

3) A pimp adds more value for her clients than a Realtor does.

4) The real story behind the Kitty Genovese case and the bystander effect. I always thought that was a straightforward case of how people lack altruism and our world is full of selfish, coldblooded, indifferent people. Levitt provides a different explanation of the events surrounding Genovese’s murder.

4) The best solutions to our hardest problems – car safety, global warming, mortality rates in hospitals – are usually cheap and so blindingly simple that no one would think of implementing them – until they are actually executed.

Am currently trying to come up with a trading strategy along those lines – we’ll see where that gets me.

Michael Covel Business Philosophies

Haven’t posted for an entire month! A lot has been happening lately in terms of finance/economics and will update really soon. A starter post to get me warmed up for more serious posts in the (very near) future.. promise!!

Taken from Michael Covel’s blog:

Bring joyful, imaginative and impassioned energy every day. You can’t fake it.
You don’t need to be ‘big’ to be good, you need to be smart.
When there is no market, create one.
Engage someone as if your life depended on it.
Nothing is more important than the wisdom to help transform someone.
Make your vision grounded in your uniqueness.
Focused on the unexamined dimensions of your efforts.
The race goes to the curious and slightly mad.
Dry obligation to anything in life will figuratively kill you.
No one gives permission. Seize the mantle.
If you can’t solve a problem, you are playing by the rules.
Hard work, sustained concentration and drive are the so-called secrets.
Telling the truth is the best defense for every situation.
Winners understand sunk costs and opportunity costs.
Plan to win, prepare to win and have every right to expect to win.
It’s in your power to change your belief systems. No one is stuck.

The Myth of Time Diversification

Something my Financial Risk Analysis professor mentioned last week:

A common argument is that stocks are safe investments in the long run because of “time diversification.” Buy-and-hold advocates argue that if you hold a stock over a long period of time, the “good” and “bad” returns will tend to cancel each other out, so time will diversify a portfolio just like how investing in multiple assets diversifies a portfolio.

The time diversification argument is only valid if there is a mean-reversion in stock returns – ie there is a negative serial correlation of returns. (In non-academic speak, this means that if returns are high today, they will be low tomorrow on average). Let’s examine the three cases of stock returns (positive correlation, no correlation, and negative correlation) and see why buy-and-hold fails in each case:

Positive correlation
Research has shown that in the short run, stock returns are positively serially correlated. This makes sense: if the S&P closed high today, it will most likely be higher tomorrow, as long as there isn’t a huge piece of bad news. Conversely, if the market closed lower, it will most likely follow its downward trend. This is how trend-followers make money. So time diversification doesn’t work in the short run.

No correlation
Even if you follow traditional academic thought and claim that stock prices follow a random walk, ie stock returns are serially uncorrelated, time diversification still does not work here. Investing over a long horizon may increase your returns over a long time, but it also increases your risk relative to expected returns. The saying “markets can remain irrational longer than you can remain liquid” holds true here – if prices follow a random walk and drift downwards for 10 years and upwards for 12 years, your return might be positive but your variance remains huge.

Negative correlation
Now let’s move on to the situation that DOES favor time diversification – when stock returns are negatively correlated. Academic research shows that stock returns do exhibit this tendency in the long run, which is nice. So time diversification does help to lower your risk relative to expected return over the long run. However, it’s easy to see that buy-and-hold is the WRONG strategy for such a situation.

Let’s say that stock returns are negatively correlated and stock prices are mean-reverting. This means that if prices were higher than a certain mean, they will eventually come down. If they were lower than the mean, they would rise. The optimal way to make money would be to then buy when prices were below the mean, and sell them when they were above the mean – a surefire way to make money if stock prices were truly mean-reverting. This strategy is known as swing-trading, and is practiced by many traders.

In any of the three cases I highlighted, buy-and-hold falls flat on its face, and yet there is an entire industry of long-only mutual funds, pension funds, “value” investors etcetc that subscribe to the buy-and-hold mantra.

That one schpiel from my professor convinced me that I should be taking his class. Now who says that all academics live in an ivory tower?

Job Schlobs

Recruitment fever has hit the LSE finance department the past couple of weeks, with my friends going stumbling over themselves to sign up for CV workshops, bank presentations, consulting fairs, that whole schbang. And I thought Wharton was competitive.

Observing the craziness over recruiting has confirmed what I’ve suspected all along: that people majoring in Finance have no idea what they’re doing. Everyone around me is applying for everything they can get their hands on: M&A, sales & trading, consulting, structuring, asset management, private banking… I knew it was getting ridiculous when a friend left a party at 12am because he needed to send out a cover letter the next day.

That same friend has also somehow made himself believe that M&A would be a very fulfilling career choice. Having done a few M&A cases a few weeks ago, I tried to convince him that it was basically 100-hour workweeks of putting together Excel earnings models and bullshit reports of “mutually strategic goals”. He’s still applying for M&A and other jobs as well, conceding that he really doesn’t know what he wants to do except that he’d like to make “lots of money”.

I think that sums up the predicament of almost every investment banker. From the book Liar’s Poker: “The analyst was a prisoner of his own narrowly focused ambition. He wanted money. He didn’t want to expose himself in any unusual way. He wanted to be thought successful by others like him. There was one sure way, and only one sure way, to get ahead: major in economics; use your economics degree to get an analyst job on Wall Street; use your analyst job to get into Harvard or Stanford Business Schools; and worry about the rest of your life later.”

Out of pure whim, I signed up for two days of the financial services fair at LSE (they had two quantitative trading firms that I wanted to talk to). Both days, starry-eyed students in business suits lined up to talk to recruiters. The line snaked from the fifth floor of the Old Building to the ground floor. Inside, students jostled with each other to crowd the recruiters at the bulge bracket banks: RBS, Goldman Sachs, Barcap, etcetc. They all asked the same inane questions (1. What’s a typical day in banking like? 2. What’s the culture of the company? 3. What skills are you looking for?), while knowing exactly what the answers were (1. Slogging from 10am to 4am, 2. We value teamwork, leadership, attitude, we’re not like other companies – but every company says that. 3. Be really good at Powerpoint and Excel, and be willing to embrace your status as scum in the corporate food chain)

I couldn’t stand the idea of lining up with a bunch of suits, so I sneaked in through the back door. I walked past the students crowding the banks, headed straight to the trading firm I was interested in (there was no one talking to them at that moment), and had a pleasant, enlightening conversation with a trader. We shook hands, I walked past more students crowding the banks, and left. The entire process took 15 minutes.

Being clear about what I’d like to do is such an advantage. I’m sorry, but I didn’t get a Masters degree to compile dumb reports bullshitting about why “Company X’s leveraged buyout of Company Y would create value for shareholders.”

Thanks, but I’d rather be making real money and having a life.