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.

Dear Undercover Economist…

Attended a talk by Tim Hartford, author of the Undercover Economist, as well as an FT column at LSE last week. (I know, I know, I’m way behind on my blogging, but you won’t believe the amount of work they throw at us graduate students. That, and all those parties on weekday nights…)

Anyways, Hartford specializes in using economics to solve everyday problems, or in his own words, “to make people happy”. Sort of like an economist’s version of that Aunt Agony page in one of those trashy teen magazines. Here are just a few of the topics he covered:

On how to be happy
Hartford mentioned that there have been many studies by psychologists on happiness. He cites a typical psychologist’s “happiness equation”, which would go something like: Autonomy + Purpose + Leisure = Happiness. Now this is absolutely ludicrous from an economist’s point of view. This equation has no intercept, no coefficient, no error term, etcetc – it violates the very principles of econometrics.

Of course, we economists are very proud of econometrics. It’s what makes economics a “science”. (Perhaps I don’t entirely agree, plus I know Nassim Nicholas Taleb would have something to say about this, but we’ll leave that for now) Now the basic idea behind econometrics is to take a bunch of data, run a regression (which is just fancy stat-speak for drawing a straight line), and try to figure out the relationships between different sets of data.

Perhaps it’s because economics has been deemed the “dismal science”, but economists, like psychologists, have been very interested in what makes people happy. So they collected a wealth of data on people’s backgrounds and how happy they were, and ran regressions. In a nutshell, they found that the happiest people were:
1) Female.
2) In school. The next happiest people were self-employed.
3) Wealthy and educated. (Surprisingly, money does make you happy)
4) In terms of relationships, from the happiest: Married, single, divorced, separated. Which is interesting because in order to benefit from being happily married, you also have to run the risk of getting divorced and being miserable. Also interestingly, if you’re unhappy with your marriage, you’re better off getting a divorce than merely separating.
5) In terms of number of children, from the happiest: 0, 2, 1, 3. (Hah! I knew kids were bad news. However, if you really MUST procreate, it seems that 2 kids is the optimal solution)

Economists also found that sex was the activity that generated the most fun (big surprise here), yet it was also the activity that people spend the least amount of time on. (tell me about it…) In general, people like being around other people – the one person that people did NOT like spending time with was their boss. But Hartford also wondered how people felt about sex with their boss, which I thought was hilarious.

Of course, as a budding economist and critical thinker (yay liberal arts education!), I need to point out that we can’t accept the results of this study at face value. Firstly, we can’t mistake correlation for causation, ie just because females tend to be happier doesn’t mean that being female causes happiness. Along those lines, it could be quite possible that these supposed factors could be autocorrelated (econ techie jargon that would take too long to explain here). But hey, if being a wealthy and married female PhD student having lots of sex and no boss/children is what it takes to boost the odds of being happy, I guess it can’t hurt to try it out (except maybe the female part).

On dating
Hartford mentioned the practice of speed dating, which provided excellent data on men and women’s romantic preferences because there was every incentive to tell the truth when they wrote down who they wanted to see again. (Men and women would only get each other’s contact information if there was a match. If they liked someone and said that they didn’t want to see them again, they wouldn’t get to see them again. If however they didn’t like someone and lied that they did, they ran the risk of having some stalker calling them every day.)

The one conclusion from the speed dating data was that people adjust their standards depending on the alternatives available. We’d like to think that we have strict standards: if we meet someone who surpasses those standards, we date them, and if they don’t, we don’t date them. However, data from the speed dating experiment showed that regardless of how good-looking the men were, women would always indicate one or two men that they’d like to see again, out of a group of perhaps 20. When there was a high proportion of good-looking men, women adjusted their standards upwards. If the group wasn’t as attractive, women adjusted their standards downwards and still chose one or two men they’d like to see again. Surprisingly, men behave the same way. (No, we aren’t all the sex-crazy bastards you’d like to believe we are – we have standards too)

On food and wine
Apparently you can get away with serving cheap wine at parties, but not with cheap food. Studies showed that bottles with fancy labels significantly increased drinkers’ perceptions of wine. Even the supposed wine “experts” could be fooled. During wine-tasting contests, a typical expert would give different scores to the same wine when it was served in the first, third and fifth glasses that she drank from.

Food, however, is not as easy to get away with. People could tell the difference between duck liver pate and dog food. However, they couldn’t tell the difference between cheap food (like chicken liver) and dog food.

… Trust economists to come up with the idea of giving dog food to people. Perhaps we really do need people like Hartford to prevent the rest of the world from burning us at the stake.

What “Everyone” Thinks

I’ve been spending the past 3 days on the “LSE City Fast Track” program, where they took selected members from the Finance department on a little schpiel to various accounting firms, banks, and financial regulatory institutions in London. It’s been an amazingly eye-opening experience, though I suspect that I had a different sort of experience from my fellow wide-eyed, eager-to-please coursemates, but more on that in a later post.

I’d like to blog about the common perception of trading, or I suppose what “everyone” thinks that they know about trading. Every time I hear the common misperceptions about trading, I have an irresistible urge to correct them, make a strong opinion, etc, but whatever I say usually falls on deaf ears. Which is very comforting, because that means very few people can bring themselves to do what I’m doing, which means that I can keep doing what I’m doing for a very long time.

My coursemates are very bright people who have all gained entry into one of the most academically challenging programs in the world at the Masters level. Most, however, have no clue about what they want to do in life. (I mean, who really does?) I don’t claim to have more financial knowledge than my fellow classmates – on the contrary, I have absolutely no interest (and no knowledge) about the whole schbang about valuations, EBITDA, strategic alignment, and all that nonsense.

However, I do know just a little bit more about speculative trading than other areas of finance, and I can immediately point out the faults in my coursemates’ views on trading:
1. You need to be constantly plugged into the news in order to be a successful trader.
2. A traders’ skills are less transferable than other areas of finance, eg in investment banking.

I’ll address the first one here, and the second one tomorrow or in the next few days. (Believe me, I have LOTS to say)

Myth 1: Being constantly aware of the news is necessary if a trader wants to be successful.
First of all, there are 2 types of traders: fundamental and quantitative. Most traders would fall in one category or the other, or have a combination of both. Fundamental traders care more about economic data, because they use economic “fundamentals” to make decisions, and probably rely more on financial news.

Quantitative traders are very different. They rely purely on price, volume, or some derivation of those figures in order to make decisions. Quantitative traders have clear, distinct rules on when to get in and out of the market based purely on price and volume.

When you mention “trader”, most people would think of a fundamental trader, and it’s easy to see why. During the Fast Track program I had an opportunity to tour a trading floor with rows and rows of traders sitting in front of 6 screens each. 1 of those screens was usually plugged into Bloomberg to get the latest economic data. It’s a common belief that once news comes out, you have to act on it in seconds if you ever want to make a profit.

Let me point out why this is wrong, very wrong. While it’s true that news like the unemployment report, housing figures, retail sales, etc do affect asset prices when they are released, this effect is often temporary. Say the market is going up, and a bad news report comes in. How many times have we seen prices dive for that day, only to climb right back up again the next day? Did the unemployment figures suddenly change the day after the news was released? Of course not. The fact is that the bad news was probably already priced into the market BEFORE the news came out. If the market was moving up before the news came out, that meant that the “smart money” (ie the insiders, the big players, the people who can move the market) felt that the market should go up.

The temporary plunge in the market was due to the actions of the common traders, those reactive traders who don’t know what’s going on. They see a bad news report and they panic, selling as fast as they can. What they don’t realize is that the “smart money” is still pushing the market up, which is why prices suddenly recover the next day.

Price, therefore, is the one true indicator about where the market is going. Financial news, analyst reports, economists’ forecasts, etc are all distractions, their effect on the markets is random and miniscule when you compare that effect to the overall market. Quantitative traders take advantage of this fact in order to make trading decisions.

However, whenever I mention quantitative trading, I often get a “oh please, not that technical analysis crap again” look from these people. Of course, I don’t blame them. They’ve grown up on a Warren Buffett “buy-and-hold” philosophy, their long-only mutual funds and pension plans have told them that THIS is the only way for them to make money in the markets. Incidentally, these mutual funds and pension plans, these buy-and-hold proponents are the exact same people who lost devastating amounts in the financial crisis.

There is a group of people who DID make a fortune though, and I can name a bunch of them: Bill Dunn, John W. Henry, William Eckhardt.. and many others. The one thing they have in common? They were all systemic traders. The evidence is overwhelming, yet people refuse to believe it even when I present it point-blank to them. They stick to their beliefs that reacting to news is the only way to make money and that markets are influenced by the so-called “fundamentals”. They stick to these beliefs even though these methods have proven time and again to lose money for most traders. There’s one word to describe a person who keeps acting in a way that harms him: irrationality.

Yet, maybe I want the world to remain this way. Maybe I want everybody to be irrational, to blindly follow those methods that have harmed them in the past. Trading is a zero-sum game, and if they want to give away their hard-earned money, I want to be there to take it. Maybe I want people to be scared of becoming a trader because they think that it’s way too hard to keep up with the unlimited stream of Bloomberg headlines. That effectively eliminates my competition, allowing me to keep doing what I’m doing for a long, long time.

Capitalism: A Love Story

Gotta love the trailer for Michael Moore’s new film.
Can’t wait!

We Don’t Trust Ourselves

My Maths for Micro professor said this during my (incredibly intense) MSc pre-sessional math and statistics course today:

“Quadratic forms are the simplest functions that are used after linear ones. They are used because they allow economists to have a handle over what is going on. However, this still doesn’t mean that economists actually HAVE a handle over what is going on.”

How true, how true.

Diversification

Apologies for the long absence from blogging, I was wrecked with an unbelievably potent virus after my last post that left me bedridden for 4 days. (I’ve come to discover that when your sister catches a cold in a foreign country, RUN). I’ve also just recently arrived in the amazing city of London! (am here for a year to do my Masters program at LSE) Still trying to settle in, but i’ll be sure to update more when I do. – School starts on Friday, urk.

An update on trading so far, things have been going pretty nicely. I’m starting to see some of the benefits of diversification, especially when it comes to big contracts. While crude oil and the S&P were having bullish runs, my system jumped into TNotes just when the stock market was exuberant. I was reluctant to go long TNotes, but my system was right – soon after, the stock markets tanked and Notes jumped. It was almost uncanny.

Of course, not all trades have been profitable. The system went long the S&P yesterday, which proceeded to tumble 28 points in a day. I exited at my initial stop-loss point of $1400, but it could have been a lot worse. Again, another reminder of the importance of stops. It was a good thing that my TNote trade (again – diversification!) more than made up for that drastic loss. My forex trades, however, seem to be losing money in small amounts. Both the USD/SGD and the EUR/JPY have not been trending for the past month – I suspect they are being manipulated. I suppose that this is one of those non-trending regimes that my system will have to ride through.

All in all, so far I’m up by a little bit (partly in part from accidental profits from the mistaken crude oil trade I did 2 weeks ago, and from a copper trade that my dad accidentally entered). I need to be patient and allow the system to do its work. So far, I’ve been pretty good in following my system’s instructions. Let’s hope I stay this way.

Random Econ Humor

Since it’s the weekend, and no one’s in the mood for depressing griping about the economy/politics anyway, (and because I’m in the midst of the most boring vacation ever and I need some entertainment), I decided to give you some Economics humor that I’m so fond of (yes, I’m nerdy like that), courtesy of economistsdoitwithmodels.com

… I guess all economists need some way of keeping ourselves sane.

The Greenback Effect

This article from the great Warren Buffett in the New York Times yesterday pretty much sums up the question that seems to be on everyone’s mind: Will the US dollar collapse?

The conventional wisdom: The tremendous amount of liquidity pumped into the financial system combined with the astronomical debt levels of the US will ultimately lead to runaway inflation. The greenback, often seen as a “safe haven” and the most trusted currency in the world, backed by the full faith of the US government, will collapse in value. Perhaps the Renminbi will become the new currency standard of the world.

My view? It’s too early to tell, but I don’t think that it’ll happen within the next couple of years. Countries (eg China) are still too dependent on US consumers to allow the dollar to fall. If China stops buying US debt, they run the risk of a major economic slowdown. However, I think that such a scenario may be very possible in the intermediate future for a number of reasons:

1) The US is de-leveraging. This means that consumers will no longer have the spending power to purchase from markets like China. In turn, the governments of these countries will decide that propping up the US dollar isn’t going to help their economies anyway, so they’ll let the dollar fall.

2) China is already seeing the danger of holding too much US debt, and is putting in some measures to reverse the effects, such as asking repayments to be made in its own currency or holding other assets besides US debt.

3) The Fed has to answer for the baby boomers’ excesses somehow. This debt is only going to get worse, and if other countries not buying debt, consumers are not buying debt (because of deleveraging), the only way to solve this problem is to print money, which leads to inflation.

The US needs to stop using the financial crisis as an excuse to keep recklessly increasing its debt.

Happens to All of Us…

Article on the “Quarterlife crisis“, as seen on Eyeweekly.com.

Not exactly related to finance, but I figure it should probably affect most people reading this blog..