Day: September 11, 2010

The Rules, Part XVIII

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

I have been invited to speak twice in the next two months on the efficient markets hypothesis [EMH].? Once in Denver, once in NYC.? Fortunately for me, the folks in Denver are paying my way, and I will take a regional train to NYC and back.

I grew up on the idea that the EMH in its weak form was true, no doubt.? No one can make money looking at past price movements.? As for the semi-strong form of the EMH, which says that you can’t make money off of any past or present public data, I believed it with some reservations.? My mother was a self-taught investor who regularly beat the markets.? She used a discipline of half utilities (“they are my bonds”) and half “growth at a reasonable price” [GARP] stocks.? She is why I went to Johns Hopkins, rather than the University of Wisconsin.

The EMH in its strong form, that no one can make money off of insider information, was doubted by almost all.? Even today, we track insiders, and there is money to be made by following them.? Even following 13F filings of successful investors is profitable to many.

Yet, the EMH is compromised even in its weak form.? When one reads academic research on the markets, what is the most durable and powerful of all of the anomalies? Price momentum, which violates the weak EMH.? That said, a lot of economic actors know that price momentum works well, and so it gets used.? And overused.

Any strategy can be overused.? Before a strategy peaks, the overuse of a strategy makes the strategy work overly well, as prices for stocks are pushed above equilibrium levels through strategy momentum.

In the long run the stock market is a weighing machine, so the short-term overshoot will correct itself eventually.? But when too many follow momentum, the market goes wild.? Volatility rises; daily moves tend to be up or down a percent or more.? During such a period, price momentum stops working for a time, until enough abandon the strategy.

The same applies to longer term strategies, like value investing, or overweighting small companies, or overweighting companies with sound financials, or low price volatility, etc.? Any one of these can be pursued too much.? When any of them is pursued too much the stocks involved will overshoot and plunge.

There is no magic strategy that works all of the time.? Smart investors have to be aware of almost all of the strategies that exist in the market, and understand when they are underplayed (buy) and overplayed (sell).

Healthy markets have multiple strategies that work.? When the strategy becomes monoculture, e.g. tech stocks, then beware.? When there is only one road to wealth, the market is in a bad place, and smart investors will hold cash, or invest conservatively away from the one thing that is working now.? Broad leadership is needed in a true bull market.? When leadership thins to one idea, it is time to take profits.

Don’t confuse brilliance with a bull market.? Try to understand where you are in the cycle of your stock picking strategy.? It does not work all the time, so when things are at the best that you have seen, wait a bit, and then take two steps back.? When things are horrible, wait a while and redouble your efforts.

Factors in investment returns move in cycles. Be aware of where you are in the cycles, and maybe you can profit from them.

Twenty Questions for the Author of <I data-src=

Twenty Questions for the Author of Risk and the Smart Investor

This is the first time I have done something like this, but I am interviewing an author of a book on Risk Management, which delves into the nature of the current crisis.? My interview occurs before the book is published, and lends to its publicity, which I don’t mind because I think it is an excellent book. The book is entitled, “Risk and the Smart Investor,” and is written by David X. Martin.? Anyway, here are the questions that I will ask him:

  1. Imagine you are talking to a bright 12-year old girl.? How would you explain to her why and how the financial crisis happened?
  2. I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.? The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.? How did you hit upon this intriguing and novel way to write your book?
  3. Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?
  4. As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness.? They did not like answers like, ?I don?t know, it could have six significant effects on our company.?? How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?? How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?
  5. In your experience, how good are the managements of financial companies at establishing their risk tolerances?? Better, how good are they at enforcing those limits, such that they are never exceeded?
  6. How do you create a transparent risk culture in a firm?? How do you get resisters to go along, even if it is management that does not see the full importance of the concept?
  7. Are most cases where a person or a company fails to diversify intentional or unintentional?? Do we put too many eggs in one basket more out of ignorance or greed?
  8. Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?
  9. I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.? Was it the same for you at Citigroup when your ?Windows on Risk? got tossed out the window?
  10. Can culture and personal judgment work in risk management ever?? Take Berkshire Hathaway ? risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger.? If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?? (Remember, you don?t want to disappoint Warren.)
  11. How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?
  12. Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?
  13. Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.? Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?
  14. Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.? Why did they miss such an obvious area of risk management?
  15. How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?
  16. I have often turned down shady deals in business, saying that you only get one reputation in this world.? How do you encourage an attitude like this in financial firms among staff?
  17. A lot of portfolio management and risk management is juggling different time frames.? Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?
  18. Most developed country economic players assume that wars will have no impact on their portfolios.? Same for famine, plague, or environmental degradation.? What can you do to get investors to think about the broader risks that could materially harm their well-being?
  19. Are Rob?s more common in the world than Max?s??? That?s my experience; what do you think?
  20. At the end of your book, one of your friends dies.? Did you mean to teach us that even if we manage our risks right, we still can?t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?
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