What do we ‘know’ about investing — but can’t prove with stats?



The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats?



The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

What do we ‘know’ about investing — but can’t prove with stats?



The statistical revolutions that have overtaken sports, business and markets have bred suspicion of any observation or assertion not backed up by hard numbers.

This is a good thing in most respects. Yet experts who study these complex realms surely have ideas about how they work based on…

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

What do we ‘know’ about investing — but can’t prove with stats? was originally published on The Aleph Blog

Here is a letter from a reader:

Hi David,

 Long-time reader of yours.  You put out some of the best blog content on the web and I am grateful for that.

I’ve got a question I’d hope you consider answering in the blog.  I’m almost embarrassed to ask it, for fear of appearing facile, but here goes:

Our economy is struggling with a lack of aggregate demand, low monetary velocity, and a whiff of deflation.  QE does not seem to be transmitting its monetary effects to the real economy, just helping to inflate asset prices instead.  So why wouldn’t we consider sending direct stimulus to households, similar to what we did in 2008-09, only on a much bigger scale?  Say there are 120MM households.  Send each one a $5k check, and if I’ve got the zeroes right, that’s a “mere” $600B we’re borrowing to disburse – about 60% of what the Fed is doing annually with QE.  Most of the money would recycle and multiply quickly to the economy (net of what gets allocated to debt paydown, and what gets banked by the well-off).  And due to some current one-times in the Federal budget, we’ve actually got a better balance sheet in the moment to do something with added borrowing/spending. 

Crazy thought, but these are uncommon times.  Curious what you think. 

Dear friend, I think about this in two ways: ethics and metaphysics.  The metaphysics are easy — yeah, let the Fed remit all of its seigniorage to the people rather than to the Treasury.  Far better than letting the government spend it.

But the ethics are touchy.  How do we define ethical taxation systems?  My view is that people should be taxed according to their increase in net worth, and at a flat rate, but with no ability to defer income from taxation.  Most wealthy people don’t care about tax rates because they can find ways to defer/reduce taxable income.  This is a major reason why you should distrust the Democrats, because their desire to raise tax rates would do little.  This is also a reason to distrust the GOP, because there is no decent reason to decrease tax rates.

We need to tighten up the definition of income in the US, and no longer allow citizens and businesses to defer income.  If we taxed all economic activity as it occurred we would have balanced budgets.

The rich aren’t paying enough in the US, not because of tax rates, but because they can hide their income.  That is the way that policy should proceed, to make the wealthy pay according to their increase in net worth.

I’ll write about this more later, but the main idea is to tax people proportionate to their increase in wealth.  That is the Bible’s solution for how people should give.



Sometimes I think regulators are in over their heads.  They aren’t talented enough to run a company, but they think they can control the excesses of financial companies.  Then there’s the Fed.  They think they can control an entire economy through the weak policy lever of affecting the views of people have for calculating what interest rates they should use to capitalize the values of assets.

Think of assets as a stream of future cash flows.  But what are those cash flows worth today, to buy or sell them?  The interest rate that makes the price and the cash flows equal is the capitalization rate, or, “cap rate.”

For years, at least in the Greenspan era, lowering the cap rate via Fed funds was the rule when times were weak.  He was the anti-Martin, bringing back the punchbowl rapidly when the party was getting a little dull.  Because of that, the economy grew more aggressively for a time, but at a price of growing unproductive debts.

The Problem

You can lower the interest rates as low as you want, but it doesn’t change the underlying productivity of the economy.  You might push asset or goods prices higher — it depends whether saving or spending is more important.  At present, actions of the Fed push asset prices higher, which doesn’t do much for the economy as a whole.  Rising asset prices do not stimulate the economy much.  Though it would be dishonest to do it, it would stimulate the economy more if Ben would rev up the “Helicopter of Happiness” and rain dollars from “Heaven.”

The Fed created the housing bubble with their policies 2001-2007.  They did that to stimulate the economy.  You can only use strong sectors of the economy to transmit monetary policy, because they can absorb more debt.

That’s true when not in a liquidity trap. We are in such a trap now, given the profligate prior Fed policy.  They did not let recessions destroy bad debts leading to a reduction in the marginal productivity of capital.  That value is so low now, that companies pay higher dividends and buy back shares.  Relatively little goes into growth via new investment.

My point is that monetary policy has some potency if central bankers are willing to inflict pain in the bear phase of the credit cycle.  With Greenspan and Bernanke, that was absent.  As such, we suffer in a liquidity trap, and one that current Fed policy will not remedy.  Far better to raise short-term interest rates and let some bad businesses fail, and grow from there.

One of the great things about the US is that people give their time and effort for things that benefit society.  It is a secular offshoot of the Puritan idea of creating a Holy Commonwealth.  We are out to save the World from itself, but now, without anything like Yahweh/Jesus telling us to do it.

I must admit that I serve in both spheres — I am an elder in my Bible-believing Presbyterian congregation.  I also serve on the Baltimore CFA society’s board, and may become a part of the board that oversees the pension plans for Howard County, should the county executive so choose me.  (As an aside, I applied for similar posts at the Maryland State level, but I fear that I am either too controversial, or too qualified.  I suspect that they don’t want people who really know the business.)

When I came to Baltimore, my boss had a number of things to teach me:

  • When someone asks you for help finding work, give him help.
  • Break off time to aid the broader interests of your industry, in this case, the CFA Society.
  • Where you have the opportunity, favor the local financial community if it doesn’t cost a lot to do so.
  • Help students and young professionals where you can.

I have made an effort to do this.  I aid people who are looking for opportunities, and I advise them.  I may not be the best, but I have been around the block a few times.  I really enjoy aiding people to find jobs in investing.  I love spending time with students, and encouraging them to think broadly about how investing works.  It is not a simple formula.

Thus I find my time pulled many different directions, and my dear wife wonders at how I do it.  The truth is, I don’t do it.  I have as many hours as all those who are alive.  It is just a question of the distractions that you block out in an internet era.

Thanks for reading me, and as Program Chair for Baltimore CFA, if you have any great speaker ideas for me, please send them to me. Thanks.

Why are TIPS yields negative out to 20+ years?  People are willing to lock in a loss versus CPI inflation in order to avoid a possibly larger loss.

Why do some people continue to invest in money market funds, bank deposits, savings accounts, when inflation is running at 2%+/year?  They are willing to lock in a loss versus inflation in order to avoid a possibly larger loss.

When the Fed adopts aggressive strategies, people will have two responses:

  1. “Yields on safe investments are too low.  I need more income.  I guess I have to take more risk.”
  2. “Policy is abnormal, and I am scared.  I know I am going to lose here, but I want to lose as little as possible.  TIPS, bank deposits, and money market funds make sense here.  Maybe some gold as well.”

The Fed is counting on response #1, but response #2 is much more common than they would like.  Now, response #1 is nothing all that great — the Fed is trying to extract value out of economic actors by making them undervalue risks, whether those risks are duration, convexity, credit, etc.  When they encourage more risk, they are trying to extract economic wherewithal out of those that invest there.  Who is the one that buys when things are hot, before they are not?  That is the target.

So be wary amid the efforts to “stimulate” the economy.  When an economy is heavily indebted, stimulus does not work.  Far better to invest your money in areas where stimulus does not play a role.  Look for healthy places in the economy that do not rely closely on the government.

Finally, don’t take minor changes by the Fed too seriously.  They are utterly convinced of their “super powers,” and do not appreciate how little control they have.  Every action of the Fed in their “stimulus” has produced progressively less response.

The Fed does not control the US economy.  They are codependent with it, and they do not act, they react.  The FOMC is hopelessly lost, with a cast of C+ students running the show — people who can’t think more broadly than the failed ideas of neoclassical economics.  As I have said before, the FOMC needs more historians, and no neoclassical economists.  Bring in the Austrians, they might solve things.  You might get a depression in the short-run, but afterwards, things would be normal.

That’s why some would rather lock in a smaller loss; this situation is volatile enough that many will want to do so.  As for me, I will try to buy undervalued companies, and make money there.

For fun, I decided to try running a test on the constant we call Pi in binary form [note headline].  Pi is the ratio of a circle’s circumference to its diameter.  It is many more things as well.  It is a unique number in mathematics.  As Linus said to Charlie Brown after meeting the kid named “Five,” “How about the name 3.14159?”  Charlie Brown says, “I think there are a lot of kids who would be named 3.14159.” (From memory, I could have botched it.)

I found on the web the first 2^15th power (32,768) binary digits for the “fractional” part of Pi. In decimal terms, it means Pi to a little more than 10,000 decimal places.

Pi is an irrational number.  That means it can’t be expressed as a fraction of two integers.  As such, in binary form, since the series does not terminate, the pattern of ones and zeroes should be random.  As such, we can do a “runs test” to see whether the number of runs is abnormal.  Too few runs: zeroes and ones alternate too frequently.  Too many runs: zeroes and ones do not alternate enough.

My expectation was that neither abnormality would occur.  But I had to follow the data to the conclusion.  As it the first 32,768 digits of Pi, it had too many runs, such that the probability of it being random was 1.26%.

I don’t know what to do with this, but my next experiment will be on the number e, 2.71828…

I’m good with math, but not great with it.  Advice is welcome…

I’ve had this idea for 15 years or so, but forgot about it until I sat down and talked with a friend who worked for a dysfunctional company that recently let him go.  My experience working in corporate America is that the best and most effective firms listen to their employees, and set up some means of obtaining their opinions on how the business could be improved.  Bad firms have managements that think that know it all, and the rank and file must merely execute what they imagine will work.

In all of the time that I worked in the insurance industry, or served on the boards nonprofit organizations, I have yet to have seen a situation where a consultant needed to be hired to solve a problem.  The middle management of the firms in question knew what the answer was, but senior management was either fighting with itself, or weak-minded.

I remember one situation where the Chief Investment Officer and the Chief Financial Officer hated each others guts, and could rarely agree.  The only way to solve a particular problem was to hire a consultant, who would neutrally give them an answer that they both would heed.

I was running a small line of business in the company, and the consultant approached me for data, which I gave him, but I asked my boss about the situation.  He told me that the company was spending roughly 7% of that year’s income to analyze the investment policy of the firm, particularly with respect to the liabilities of the firm.  I said to my boss, “If you gave me 3 months, I could solve this project on my own, and the cost would be 3% of what the consultant charges.”  He laughed and told me about the fighting above us, that led to the costs.

As it was, the consultant gave advice that was less detailed than I would have given, but was valuable, though embarrassing to the insurance company — they were invested two years shorter than they should be.  There a free lunch to pick up income and reduce risk.  You could go three years longer if you wanted to optimize risk.

Lovely, but if management had just asked its line of business actuaries to answer the questions it all could been solved for a small fraction of the cost, and with more precision.  Also, though no one talked about it at the time, it really showed that senior management really did not understand the core business, which was earning a spread over liabilities adjusted for risk.

I have another experience working with a non-profit where the executive was weak, and would never hire anyone more talented than himself.  As a board member, I was always shocked with how badly the place was run, but the board members suffered from the same disease; few were competent.  Management liked having incompetent board members.  Worse, the incompetent board members did not like anyone suggesting that there was a better way to do things, which is why I eventually left.

This management team hired consultant after consultant on things that I felt were answerable from resources within.  But being weak-minded, they did not trust their middle management to answer basic questions.  A lot of money was wasted in the process, which was particularly painful, because the non-profit did not have a lot of resources to spare.

Do You Really Need a Consultant?

There are cases where hiring a consultant is needed, but the first question should be whether those who work for the firm, particularly middle-management might be able to do a better job with it for less cost.  Going back to the first firm mentioned, I was hired by a division of the firm to provide exactly that expertise.

Even if employees are a little short of the expertise needed, giving the project to them will develop the expertise internally to deal with the question at hand and handle greater questions later.  More, it will improve morale, as employees deal with difficult problems and triumph over them.  If you want to read about one vignette in dealing with this, you can read it here.  It made me choke up as I re-read it, because it was such an amazing transformation/comeback that no one expected.

But the first priority of people management in a firm should be hiring bright people and set them free to act.  There was one firm I worked for where this was actually done, where the man in charge hired people, all of whom were brighter than him.  I was one of them, and I did not realize at the time that he had hired me to be his #2.  Small organization, informal, yeh.

He wasn’t always easy to deal with, and on a number of occasions people in our unit would come to me near the end of the day, and say “can we talk?”  When I learned the topic, I would say, “Close the door.”  Then I would listen to their grievances.

I responded to them, “Look, our boss is imperfect, but he means well, work with him.  He was courageous enough to hire people brighter than himself, which few will do.  Reason will win out here, and I will help the process along, but be sweet reason incarnate, try to convince, don’t gripe.”

And as it was, all such situations were resolved, and we produced a far better firm, with good results to the client, and good morale.  (And I quietly led useful change, which was the way I did things in my younger days.)

A New Business

So, if you as a management team think that you need a consultant to solve your problems, e-mail me.  For a nominal fee, I will ask you whether you have set up a culture with bright people who can solve problems, and whether they have tried to solve your problems.  If you have tried that, and your team can’t do it, yes, a consultant is warranted, otherwise not.  But it also means that you have hired wrong.  Get some talent in your door that can solve tough problems.

In essence, I would be a consultant telling you not to hire consultants, and to build up the talent base of your organization, such that you would never need me, or anyone more expensive than me again.  I would be a very cheap way of improving your organization.


But what happened to the group where I became the #2?

Well, I briefly became #1 when the boss left prior to a merger.  We merged into a larger organization that didn’t really get how insurance assets should be run.  As it was, they lost the mandate, long after I was gone.

The rump of the organization now has a five star rating from Morningstar for high-yield bond management, and is happily managing assets in Charm City (Baltimore), while the immediate parent company (that they were sold to) is in NYC.

Oh, the boss who left?  He eventually found work  managing bonds near DC.  A good guy, if a little irascible. He is still a friend.  In fact, all the people I mentioned are still friends, because I don’t make permanent enemies.  I just try to promote what is best for all.