Quantitative Methods – Page 25

Book Review: All the Devils are Here

Posted on 9 December 2010 by David Merkel

Have you ever seen a complex array of dominoes standing, waiting for the first domino to be knocked over, starting a chain reaction where amazing tricks will happen?? I remember seeing things like that several times on “The Tonight Show with Johnny Carson” back when I was a kid.

When the first domino is knocked over, the entire event doesn’t take long to complete — maybe a few minutes at most.? But what does it take to set up the dominoes?? It takes hours of time, maybe even a whole day or more.? Often those setting up the dominoes leave out a few here and there, so that an accident will spoil only a limited portion of what is being set up.

Those standing dominoes are an unstable equilibrium.? That is particularly true at the end, when the dominoes are added to remove the safety from having an accident.

Most books on the economic crisis focus on the dominoes falling — it is amazing and despairing to watch the disaster unfold, as the leverage in the system is finally revealed to be unsustainable.

This book is different, in that it focuses on how the dominoes were set up.? How did the leverage build up?? How was safety ignored by so many?

The beauty of this book is that it takes you behind the scenes, and describes how the conditions were created that led to a huge creation of bad debts.? I was a small and clumsy kid.? My friends would say to me during sports, “There are mistakes, but your error was so great that it required skill.”

The same was true of the present crisis.? There were a lot of skillful people pursuing their own private advantage, using new financial instruments which were harmless enough on their own, but deadly as a group.? So what were the great financial innovations that enabled the crisis?

Creation of Fannie and Freddie, which led to an over-issuance of mortgages.
Securitization, particularly of mortgages.? This led to a separation between originators and certificateholders. (And servicers, though the book does not go into servicers much.)
Having parties that guarantee debt, whether GSEs, Guaranty Insurers, the Government, or credit default swaps [CDS]
Loosening regulations on commercial banks, investment banks and S&Ls.
Regulatory arbitrage for depository institutions.
Loose monetary policy from the Federal Reserve, together with a disdain for regulating credit.? They saw Mexico and LTCM as successes, and thought that there was no crisis that could not be solved by additional liquidity.
Bad rating agency models, and competition among rating agencies to get business.
Regulators that required the use of rating agencies for capital modeling.
The broad, misinformed assumption that real estate prices only go up.
The creation of Value-at-risk, a risk management concept that has limited usefulness to true crisis management.
The creation of CDOs that did not care for much more than yield.
The development of synthetic CDOs, which allowed securitization to apply to corporate bonds, MBS, and ABS not owned by the trusts.
The creation of subprime loan structures, where are that was cared for was yield.
The creation of piggyback loans, so that people could put no money down for a home.

There are no heroes in this book, aside from tragic heroes who warned and were kicked aside in the hubris of the era.? Goldman Sachs comes out better than most, because they saw the crisis coming, and protected themselves more than mot investment banks.

I learned a lot reading this book, and I have read a dozen or so crisis books.? I didn’t learn much from the other books.? In this book, the authors interviewed hundreds of people who were integral to the crisis, and read a wide variety of sources that wrote about the crisis previously.

I found the book to be a riveting read, and I read it cover to cover.? I could not change into scan mode; it was that well-written.

This is the best book on the crisis in my opinion, because it takes you behind the scenes.? You will learn more from this book than any other on the crisis.

Quibbles

They don’t get the difficulties of being a rating agency.? There is the pressure to get things right over the cycle, and get it right on a timely basis.? These two goals are contrary to each other, and highlighting that conflict would have enhanced the book.

Who would benefit from this book:

Anyone willing to read a longish book could benefit from this book.? It is the best book on the crisis so far.

If you want to, you can buy it here: All the Devils Are Here: The Hidden History of the Financial Crisis.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

On Investment Modeling, Part 4

Posted on 24 November 201024 November 2010 by David Merkel

I thought part 3 would be the end, but I ended up with one huge and good comment from a friend.? A real friend, not a Facebook friend.? I will respond to it in pieces.

Good article and series. A few comments and/or questions for you. First, there is no doubt that both value and momentum work. And while I happen to personally be a big believer in (certain) trend-following approaches, the way in which Covel interacts with people is childish at best. There is room for professional discourse and disagreement, but he has little interest in being professional about anything?at least in the blogosphere/twitterverse world. So, keep at it?be a gentleman and let the other chips fall where they may. Now, a few other areas:

I try to stay polite.? Sometimes I fail, but thankfully, it is not common.

1. First, I?d be interested to have you elaborate a bit further (or point me to a different post) on your views of the Carhart factors. In my mind, there is no doubt that they are betas?but at the same time, there is also no doubt that those betas can and should be used (carefully) as alpha factors as well. Much as my brain has been trained to think about them as simply betas, I?m more than willing to think about them in both ways. They aren?t mutually exclusive, are they?

I have no other post on this.? This series was meant to bring this idea buried in me to the surface.

I think the thing that set me off here is the value factor.? Value is regarded as a risk factor, when if you own enough stocks with the value factor, you will outperform over the intermediate term.? The same applies to momentum, it is a risk factor, but it tends to outperform.? The same can be said for size, small is usually a winner because of neglect.? Beta tends to be negatively correlated with outperformance.

If the factors were neutral, having zero expectation of future performance, they would be betas.? But that is not true even of “beta.”? Thus, most of the time one can make money by tilting to the moneymaking sides of these factors.

Recently, there was an analysis of Berkshire Hathaway for the last decade, showing Buffett had no alpha.? But if you looked at Berky versus the index, Berky beat it by 6%/year.? Buffett asks whether companies are cheap.? If he buys a company because it is specially cheap, or because its associated “risk” factors are cheap, that should be measured as skill, not taking risk.

If we add enough “risk” factors to the analysis, most alphas disappear.? But the ability of managers to buy when a risk factor is cheap does not go away, as does their ability to be “late followers” and lose money as so many retail investors do.

2. Second, and importantly, I don?t believe that every investment strategy can be boiled down to a fairly simple mathematical/quantitative approximation. Therefore, not every strategy can be tested in a purely academic sort of fashion. Take Covel?s trend-following, for instance. There are obviously many ways to do trend-following, but few are so simple as to easily do an historical test. It?s NOT simply momentum (as you well know!), and while momentum and trend-following certainly have some correlation, it would be a disservice to the TF crowd to view one as a proxy for the other. The buy and sell rules, timing of entry points, level of stop loss, etc. are hugely crucial to the success of the strategy.

You are right here, mostly.? What we test are only the quantifiable aspects of the strategy.? We don’t test, we cant test nuances.? Nuances will get lost in the noise.? We are out to test the first approximation of a strategy, not the strategy itself.

Most managers have an initial screen that winnows down the universe of stocks that they will then use their abilities to analyze.? Managers think that only a subset of stocks are worth their time, because that pool is likely to outperform, now let’s get the best of those.

In this sense, we are not testing the fullness of a manager’s processes, but only his initial quantitative screen.? Processes beyond that are alpha, whether positive or negative.

As one who has sat through many dog-and-pony shows (and you, friend, more than me), most managers fall into buckets off of their screens.? What is their investable universe?? We test that.? We can’t test the fine gradations beyond that — the law of small numbers interferes.

But what I will argue regarding trend following is that there is some measure of momentum that explains over 70% of the results of a wide number of trend followers, much as Buffett could point to the “Superinvestors” and claim that they were all one tribe, though the details differed considerably, much as Covel has done with trend following.? The first approximation of the group element is the important part tested.? Maybe we need to use principal component analysis to tease it out, but we do need to simplify the broad parts of the strategy for testing.? We can test the broad stuff.? Beyond that we are stuck.

3. So with #2 as an assumption, the only way to analyze TF is as a group of investors. Is there survivorship bias? Yes, but you have that with value guys, too. Is it enormously dependent on sticking with the system, even when it?s not working? Yes. Is there a good sample of auditable accounts out there? No?not so far as I?m aware. I think the issue that Covel has is that the majority of the best investment returns people have ever put up are from the momentum/TF crowd. However, one should very clearly separate investing from trading. The trading crowd has the ability to put up ginormous returns, but at what cost? Huge volatility, gigantic turnover, etc. that most people are not willing to live with.

Let Covel and his friends try to raise money from the institutional investment community.? We may admit that momentum works, but not the ability to consistently make money off of price/volume action when managing a large amount of money.? If they do have that skill, we need to explore it, and let the behavioral investors analyze it so that we get a first approximation, a factor, to explain it.

Survivorship bias? You bet that is there.? That is why we test mechanized first approximations to a strategy, not the strategy itself.? We test tribes, we don’t test families, much less individuals.

So in the end, as you?ve said before, it comes down to finding a system/approach that has shown the ability to work well for others and sticking with it through the tough times. No approach to investing/trading will be absolutely perfect every month, and most people lack the discipline to actually make it work over time. They switch from system to system, at the most inopportune times.

Thanks for the good work?keep it up!

You would know better than most that though I am generally a value investor, my own strategies are different because I use industries as my primary screen in investing.? And it is nonlinear — I look at those that are running, and those that are dying, but not the middle.? I consider macro factors that many do not, whether I am right or not.

I am one of those managers that would be hard to measure, if one wanted to measure things precisely; I don’t screen, as most managers do.? But I consider value, momentum, and mean-reversion effects to be givens, while I try to analyze what industries and companies will do well.

And that is a reason why I have not fared well with fund management consultants.? Like Covel, I do not fit their paradigm.? Unlike Covel, I would like to fit their paradigm.

But no, I am happy for the present to attract individual investors who want to outperform on a risk adjusted basis over a 5-year? period.? That is my forte, and I will pursue it with investors as my firm goes live at the beginning of 2011.

On Investment Modeling, Part 3

Posted on 20 November 201022 November 2010 by David Merkel

This is the last piece intended in this series, but I know that I will get a some abuse for it.? One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.? Thanks.

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Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.? Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.? Another win for value investing.? I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.? No envy here.? I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.? I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.? I write this as a convinced value investor.

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Far better to try to do a general study.? The trouble is that it is difficult to segment the market into value investors, and everyone else.? The category is squishy.? Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.

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So, what are we left with?? We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.? The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.? Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.? For value investing, it has worked.? Value factors have outperformed.? I love being a value investor, and I have been better than most of my competitors.

But that is not enough.? Price momentum factors have also outperformed.? Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.? He had more freedom to pick trend investors than Buffett did to pick value investors.? I give Michael Covel a choice:

Are you willing to recognize that value investing works, even as momentum investing works?
Or, do you end up a narrow-minded man who only sees one way to make? money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.? I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.? On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.? Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.? I hate that.? A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.

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Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

Segment investors, and analyze their performance
Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.? I agree with those, and let Michael Covel agree with me.? I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.? Why not incorporate both value and momentum into your investing?

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Update: here is a transcript of the discussion with @Covel:

Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.? There are five parts, and you would do well to read them carefully.? My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.? But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.? I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.? If you get to Baltimore, lunch is on me.

On Investment Modeling, Part 2

Posted on 18 November 2010 by David Merkel

Before I begin tonight’s piece, one small thing that I want to point out from my last piece was that though my models were a few years ahead of the life insurance industry, the two most important things that I did were:

Not optimize for best return, even if risk adjusted.? I gave extra weight to avoiding the downside.
Added in the details.? My models were entirely home-grown, and took advantage of my programming abilities to come to a sharper result.? I am not a good theoretical mathematician, but I am good at using math to solve practical problems.

The idea is model completely, and don’t ignore scenarios that could not happen.? My interest rate model had scenarios that mimicked what we actually got, though what we got was not a high probability.

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One of the themes that I came away with from the Denver conference last week was look through the windshield, not the rearview mirror.? But much of the investment industry, and retail investors are destined to? look through the rearview mirror.? I, as an actuary, have been unfairly accused of driving life insurance companies through the rearview mirror, look at this and say that we can look through the windshield, but we have to be more than the common shlubs who are the majority of the market.

To do that we have to adopt an independent disposition, and not care about raising funds, but only earning returns for clients.? If we build it, they will come.? In one sense, it is like someone who has a beautiful singing voice, but who avoids pride, and admires his voice as if it were someone else’s voice. (Apologies/Credit to C. S. Lewis)

The main point here is to look through the windshield, and exercise intelligent independent judgment.? Analyze the situation, and figure out where there is an advantage as a businessman.? The tools of modern portfolio theory will be useless here, so ignore them.? They only sharpen/obscure our understanding of the past/present by calculating parameters that are not stable or predictive.

The only positive thing about Modern Portfolio Theory is that it sidelines a bunch of bright guys who would otherwise be competitors in the markets.? Sun Tzu would admire this tactic — getting a large portion of the opposition to become peaceniks because the expected value of the war is zero or negative.? It’s as if an economic Tokyo Rose is broadcasting that competition in financial markets is futile — in aggregate, everyone will get average performance, so why fight to get better performance?? It’s futile; give up; go home.

I would simply say there is always a decent amount of lazy investors in the market. Smart investors can get better returns through paying careful attention to what seems to offer the best returns on a forward-looking basis.

Part of looking through the windshield is avoiding noneconomic constraints.

1) Do I care where a company is located? Yes. I want a place where the rule of law is honored.? As many have commented at my blog, does that include the US?? Yes, for now.? Global diversification is important.? That said, it will be interesting to see what will happen to investments should we see tariffs, foreign exchange controls, and expropriation.? At least in you own home country you only have to deal with the “devil you know.”

2) Do I care whether a company has a large or small market capitalization?? Not now.? Even if my asset management firm grows, I will adjust my strategy to include attractive small caps at lower target percentages.? If my buying begins to affect the stock price, I will take smaller positions.

3) Do I care if a stock is “a growth stock” or a “value stock?”? No, I care more about industry and firm prospects relative to price.? I will pay up on occasion.? Still, mostly I try to buy them cheap, and it biases me toward “value stocks.”

4) Do I care about whether a stock is volatile or not?? Yes.? Stock price volatility is a sign of low creditworthiness, and usually I only buy higher quality stocks.

5) Do I care about price momentum?? Yes.? Typically, I buy companies that have strong current momentum, or poor momentum over 3-5 years.? Is it what I focus on?? No.

6) Do I care if I have an “undiversified” portfolio?? No.? I want to be in the right place at the right time on average.? Mimicking the index is a recipe for mediocrity.

7) Do I care if I am holding cash?? Yes.? I’d rather be in stocks, but will build up cash if I have to.? Cash moderates volatility in a concentrated portfolio, and allows for opportunistic purchases.

8 ) Do I care if I underperform?? You bet.? It burns a hole in my gut.? But it doesn’t make me change my methods.? It will make me sharpen my analyses.

A large part of the idea is to focus on risks, not risk.? Academics focus on univariate risk, with its simplistic math — beta, standard deviation, skewness, and all of the half-measures and ratios that stem from them.? I can’t model my methods in full, but I look at the risks in particular for each of my investments.? Every investment has to justify its existence in my portfolio independently.? I don’t do correlations; they are not reliable.

I also don’t go in for the four Carhart risk factors — beta, size, value/growth, and price momentum.? I don’t think of them as “betas,” but as “alphas.”? These are factors that can be taken advantage of when they are cheap or rich.? They are not risk factors, they are simply factors.

In closing, there has been a shift in the environment from inflation to deflation.? How does that affect investment choices?? My guess: buy well-financed companies with a low price to tangible book.? Stagflation?? In the ’70s the answer was low P/E with pricing power.

The closing segment of this series will focus on how to do statistically valid studies of investment performance.? I know at least one person who may be annoyed by what I say, but it is important to try to be fair in investment analysis, lest we lead others astray.

On Investment Modeling, Part 1

Posted on 16 November 2010 by David Merkel

Investing is a battle between the past, present, and future.

The past tempts all to look and see what has happened, and extrapolate, or assume mean-reversion.? It tempts academics to use simplistic math, and calculate alphas, betas, standard deviations, R-squareds, and more.? They consider the past to be prologue.? They estimate assumptions for asset allocation off of averages of past returns, sometimes even making the error of arithmetic averages, rather than geometric averages.

But the past is the past.? It happened, and it usually has little bearing on the future, aside from momentum effects when few are following momentum.? Those who calculate models off of historical data describe the past in a stylized way.? The past is a historical accident; generalizing from it in precise terms is difficult.? In some ways I think that analogies from the more distant past have more validity, partly because they are less known by the average market participants.

Those who use the past for asset allocation are doomed for failure.? The past is the past.? Bonds returned well in the past, but the best estimate of a bond’s return over its maturity is the YTM now.

The present intrudes on the past that way. With stocks, the same thing happens measuring current P/Es, P/Bs, P/Ss, versus long term average returns.? It is far better to be a buyer when a stock is out of favor, but not dying.

In the present we can estimate implied volatilities from options, and even implied correlations in certain cases.? Real-time as those are, they give the knife-edge of the estimate of how things react presently.

But as for the future?

We have precious little in the way of clues.

Yes, value and momentum may give us some guidance when they are underfollowed, but they are poor and weak guides to the future.

The truth is that we just don’t know.? Our models are often regime-dependent, because data has been collected over a limited period of time.? I smiled at the Denver conference that I recently attended, as models were trotted out that were based on 20 years of data or fewer.

Now, I don’t blame the researchers, including myself, much.? We all look for the biggest, longest set of clean data we can find.? We realize there are things that we aren’t testing.? We should know that there are hidden variables that haven’t varied much during a regime, that might our results quite different when the regime shifts, but for the most part those are Rumsfeldian “unknown unknowns.”

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Excursus: I once did a seemingly hopeless project to try to estimate withdrawal sensitivity to interest rate movements on deferred annuities.? I completed it in 1998, with 16 years of data, on hundreds of thousands of policies.? Big known problem: interest rates had fallen over the whole period.? But the need for the project was evident, because interest rates had nowhere to go but up, right?? With a little clever modeling, though, I teased out the statistically significant result that a one percent rise in the difference between competing and our deferred annuity yields would lead to additional withdrawal of 2%/yr.

At first, I thought 2% was too small, but then I realized it was an option not efficiently exercised.? So I left padding? in my analysis, assuming that if the market ran away and we couldn’t keep up, that withdrawal levels would be far higher than a ratio of 2.? I built my asset-liability model, which had the capacity of running multiple scenarios developed from my multivariate mean-reverting lognormal interest rate model, built from my homegrown quasi-monte carlo multivariate random number generator.

I did not set the model to optimize investment policy.? Instead, I set it to do well on two criteria that I weighted: minimize losses in the lowest 5% of the tail, and best average result.? When I got the results, they looked wrong; but the more I looked at them, I realized they were right.? I did two versions, one that allowed for the use of interest rate options, and one that didn’t.? Knowing? that my investment department had no quants, I realized the options would be a tough sell — indeed, they chose the option without them.? But then they asked me, “Dave, these are deferred annuities; crediting rates vary annually.? You’re telling us to invest three years longer than we are currently in duration terms — that’s huge.? And why 20% in 30 year bonds?”

My answer was a simple one.? We were all concerned about rates rising and withdrawals that would occur from that.? We missed the other issue, because interest rates can only go up from here, right?? Floor guarantees.? If rates continued to fall, we would have no ability to lower rates further on an increasing amount of the policies; those policies also would have low lapse rates.? When I explained how close we were to the floor we were they caught on, and realized that we had a rare “free lunch.”? Limit risk and improve returns all at once.

Actually, it meant we had mismanaged the business previously, because it was the first withdrawal study in the history of that line of business, but at that point it increased the profits of the company significantly.? What’s more — rates didn’t rise as we all knew they would.? The change in investment policy saved the insurer that merged/acquired the company a lot of headaches.

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So, with whatever our results seem to be, we have to take caution and not overdo what our results seem to prove.? Risk control should be the order of the day.? Buffett said that all he wanted in life was an unfair advantage, but with our limited knowledge of how markets work, we have to realize that we probably have less advantage than we think.

I have more to say here, but I have to hit the publish button — too long already; more coming in part 2.

Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Posted on 6 November 20109 November 2010 by David Merkel

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.? The CFA Society of Colorado is co-sponsoring it.? As a guide, they have asked my panel to comment on this piece? by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.? I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren?t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python?s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.? The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.? Market prices reveal the current expectations of the market as a knife edge — sharp but thin.? They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.? Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.? Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.? The main thing to remember is that human nature never changes.? In aggregate, we don’t learn from market behavior.? We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.? That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.? Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.? Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.? The truth is: it’s never different, or, it’s always different.? Human nature in individual and aggregate, does not change.? Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.? One thing that I have focused on in my money management ideas, is to avoid thinking short-term.? There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.? Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.? If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.? If I find a more? attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.? I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.? Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.? Think of Fannie and Freddie.? They ran on thin capital bases for years, thinking that they could never lose.? So long as housing prices continued to rise, they were right.? And for many, the idea of housing prices falling in aggregate was ridiculous.? Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.? The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.? Scientists are biased? like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.? Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.? Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.? That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.? Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”? Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.? But, how well can we predict that?? I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.? I would like an infinite stream of patsies to soften the blow if I make bad decisions.? In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

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So, after all that, aside from point one, I agree with Montier almost entirely.? What a great article he wrote, and what a great article to stimulate the panel that I am on.

Portfolio Rule Three

Posted on 2 October 20103 October 2010 by David Merkel

One side benefit of deciding to start up Aleph Investments, LLC, is that it is forcing me to write out articles on my rules.? When I was writing for RealMoney.com, I wrote a number of articles about my eight rules, but I only wrote about four out of the eight rules.

Before I write about rule number three this evening, I would like to bring you up to date on what I am doing with Aleph Investments, LLC.? This past week I incorporated the business, and in this coming week.? I will be registering as an investment advisor.? I will be managing equity money, on both a long only and hedged basis.? I have yet to choose a custodian and clearing broker, but I am working on this.? Given the state that I am domiciled in, Maryland, there may be delays but I suspect I’ll be up and running by late November or early December.

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Let me give you a little history of how the eight rules came to be.? In 2000, I had an e-mail discussion with Kenneth Fisher.? I explained to him what I had been doing with small-cap value, and how I had done well with it in the 90s.? He told me to forget everything that I’ve learned, especially the CFA syllabus, and look for the things that I can do better than anyone else.? We exchanged about five or so e-mails; I appreciate the time he spent on me.

So I sat back and thought about what investments had worked best for me in the past.? I noticed that when I got the call right on cyclical industries, the results were spectacular.? I also noticed that I lost most when investing in companies that didn’t have good balance sheets, no matter how “cheap” they were in terms of valuation.

I came to the conclusion that size and value/growth were not the major determinants of my investing success. ?Instead, industry selection played a large role in what went right and wrong with my investment decisions.? So, I decided to formalize that.? I would rotate industries with a value bias.? But that would have other impacts on how I invested.? One of those impacts is rule number three.

I formalized the first seven of the rules in 2002, when the strategy was two years old and seemingly performing quite well.? I began doing what rule number eight states sometime in 2004, and reluctantly added it to the seven rules sometime in 2006.

With that, on to rule number three:

Stick with higher quality companies for a given industry.

There are three simple reasons for why rule number three works:

First, companies with lower debt levels within a given industry tend to be more profitable than companies with higher debt levels that industry, contrary to what the Modigliani-Miller theorems state.
Second, many investors, both retail and professional, have a bias toward what we might call “lottery ticket stocks.”? Many people swing for the fences in the stocks that they buy and accept high risks in order to achieve a high return.? On average, this strategy does not work.? In general, buying high beta, high volatility stocks is a recipe for disaster and buying low beta, low volatility stocks tends to earn money better than the market averages.
Third, if you are rotating industries, there are two ways to do it.? These two ways are not mutually exclusive, you can have part of your portfolio in one strategy and part of your portfolio in the other.? Method one is to look for trends that are clearly going on, but that the market has not fully discounted.? In this case, one can buy companies with excellent or good balance sheets because the trend will carry you along.? Method two is to look for industries that are sick but not dead.? In that case, you only select companies with excellent balance sheets.? This is how it works: if the industry remains sick, weaker competitors will be destroyed, capacity will exit, and pricing power will return to the survivors.? If the industry?s pricing power suddenly improves, then all of the companies industry will do well.? The one with the excellent balance sheet will outperform the market as a whole.? That the ones with poor balance sheets do even better is not a concern.? The idea is to avoid losing money; don’t take the risk by buying the “lottery ticket stock.”

For what it is worth, this same idea not only works with stocks but it works with bonds as well.? If you read the book Finding Alpha, the author has an extensive discussion on why high quality bonds outperform low-quality bonds over the long haul.? In general, corporate bond investors underestimate the costs of default risk.? BBB bonds do best, followed by AAA bonds, and then other investment grade bonds.? After that, the lower the rating of the bond the worse they do.

The same is true of stocks, which is why it pays to look at where the market is in its liquidity cycle.? In November of 2008 through March of 2009, it made a lot of sense to buy junk bonds, and I did so for my church building fund.? Though I didn’t say it at the time and did not act on it, it was also in hindsight the right time to buy junk stocks.? Oh well, that’s water under the bridge.? I tend not to take the risk of buying junk stocks because I don’t want to lose money.? I did well enough by adding to more cyclical names that had strong balance sheets.

Two notes before I close: first, industries tend to have preferred habitats.? In other words, typically the difference between the company with the best balance sheet the industry and the company with the worst balance sheet industry is not all that great.? Why is that?? If you’re in the same industry, typically you have similar levels of fixed costs versus variable costs, and you face the same levels of variability in sales.? These two factors together will lead an industry to a preferred level of financial leverage.? But even though the difference might not be that much between the company with the best balance sheet and the worst balance sheet within the industry, when pricing power is weak that small difference is significant.

Second, I am a proponent of “good enough” investing.? What I am saying here is that it is very difficult to achieve optimal results, and that if you try too hard to achieve optimal results, it is likely that you will do worse than good enough results.? The demands of perfection kill.? Size your goals to what is humanly possible.? My methods allow me to sleep at night.? My methods allow me to step away from my computer, and spend time analyzing what really might matter.? I can go visit clients and not worry that something is going to blow up on me.

This is not laziness on my part.? It is my view that most investors can do well enough in investing at low to moderate levels of risk.? But at high levels of risk, you have to get too many things right too much of the time in order to succeed.

That’s all for now.? Back next week when I write about rule number four.

Book Review: The Quant Investor’s Almanac 2011

Posted on 1 October 20101 October 2010 by David Merkel

This is an odd book.? It runs through the year highlighting the US economy data releases week-by-week in 2011.? It describes ways in which the data releases affect the behavior of markets on average.

There are many interesting articles in the book, but there is little in the way of an overarching theme, or anything that might say, “And here is how it could work for you,” even though quants typically only trot out only their formulas that have weakened, while keeping their potent ideas private.

I found it disappointing.? Hey, but maybe someone else will love it.

Quibbles

This book is useless to the average investor, who does not trade futures.? Personally, I have experienced that trading around data releases is usually a zero-sum game.? Part of that is due to the inaccuracy in the data.

Who would benefit from this book:

If you run a quantitative hedge fund, and aren’t aware of the government data news flow each week, or how it can be used for profit, then this is the book for you.

If you want to learn about some obscure quantitative strategies just for fun, this could be a good book for you.

If you want to, you can buy it here: The Quant Investor’s Almanac 2011: A Roadmap to Investing.

Full disclosure: I was mailed a copy of the book without asking for it.

My Interview with David X. Martin

Posted on 27 September 201028 September 2010 by David Merkel

I had the pleasure today of interviewing David Martin who wrote the book Risk and the Smart Investor.? Unlike most of my book reviews, I have the fun of doing a voice interview and doing a written Q&A as well.? This piece will go over my voice interview.

Before I start, why did I decide to do so much with this book?? I did this because I have a love of risk management.? As I read through his book, I sensed a kindred soul who really got what is behind risk management.? I will not put out this much effort for an ordinary book.? I really liked this book, and after my voice interview I can say that I really liked David Martin.

My first question to David Martin was to ask you what motivated him to write the book.? He replied to me that as he had gone through life and learned things, his satchel filled up more and more.? The book was a way of emptying his satchel and giving back to average people.

If I might interject, that is my reason for writing this blog.? I’m not in it for the money; I don’t think David Martin is either.? But for some of us, when you have learned a lot, you feel a need to share it with others, not so much for your ego, but that others can benefit.

My second question to him was, ?If you could make a few key changes to the way we do risk management at financial firms in the United States, what would they be?”? After a pause, and saying that’s a big question, he gave me the following answer:

1) Risk management must be holistic.? It must look to the strategy being pursued, the risk involved, and then the capital needed to pursue such a strategy.

2) The risk manager must not only have a seat at the table but must have a voice at the table, with an independent channel to the Board of Directors like the internal audit function.? The Directors have to be aware of the risks that the company is taking.

3) Risk control must be grounded in reality.? It’s fine to have a quantitative model, but after his run for a while, do you test to see how it has performed?? (David Merkel: It is similar to what happens good insurance firms.? Good firms take the results of their valuation work and feed it back into their pricing, so that they do not under- or over-price their products.)? Testing is key.? Was the model truly predictive?? Did it really work?? Did you compare the results to half a dozen alternative models?

4) There are two visions on risk management.? Vision one is the huge screen in front of the risk manager, with advanced math and analytics, that takes in all the data, and allows the risk manager to make simple adjustments in real time to the quantitative feedback.? Vision two is having people with good business judgment look at the state of the markets and the positioning of the financial institution and making informed decisions.? Like me, David Martin favors the second vision.? Models will never be so good that a businessman with good judgment will be inferior.? This is one place where John Henry will beat the steam drill.

He added his experience the time that he met Peter Drucker.? He asked Drucker how one could predict the future.? Drucker answered that one could predict the future by attempting to create the future.

Now what Drucker said was not dumb, in my opinion.? And David Martin followed that advice by helping to create principles for risk management for buy side firms and for directors of mutual funds.? After all, why wait for the problems to come to you?? Why not create best practices now, and do better business for your clients, making yourself more immune to future lawsuits?

David Merkel: As Cordwainer Smith said in his short story ?Mother Hitton?s Littul Kittons,? “Bad communications deter theft; good communications discourage theft; perfect communications stop theft.”? The idea here is that good business practices are best for the client and the business in question.? Before you get sued, why not put something into place that minimizes your probability of getting sued, by maximizing the probability of doing business right?

My third question was: “Most of my readers are amateur investors.? What would you want to take away from your book?”

He began by talking about process and learning.? There are no magic ideas.? You’ve got to do the dirty blocking and tackling of learning about investments so that you can make intelligent and informed decisions about what you do.? Further, you have to be disciplined about your decision-making.? Don’t be haphazard in making choices.? (As David Merkel has said for a long time: Decision triumphs over conviction.? Discipline yourself to make your investment decisions businesslike.)

He added that all of us need an internal Board of Directors.? Friends who can counsel us when we are stumped.? He himself has such a Board of Directors ? trusted advisors will help when he can’t figure the situation out.? If David Martin needs such a group of men, how much more how much more do average investors like you and me need such advice?

My fourth question was, “What potential problems are under followed in the present financial environment?”

He paused and explained to me that his ideas here are tentative.? Many have been asking him this question, but he is less certain about what the right answer is here.? He then talked to me about information risk.? There are risks to financial systems being hacked. ?Financial companies need to verify the validity of transactions before executing on them.? He mentioned a parallel about the noise the present environment when you get so much spam relative to legitimate mail.? He himself hired a hacker at one point to see how the financial systems of the firm he was working for could be compromised.? He was surprised on how easy it was to do.

As for financial reform, he expressed some skepticism because most of financial reform is fighting the last war.? They are not looking through the windshield, they are looking through the rear view mirror.? They need to look at what the next set of problems might be.

He then said that we have not learned our lessons from the current crisis.? We have beliefs of our country, for which we have not counted the costs.? “Everyone deserves a house.”? “Everyone deserves quality healthcare.”? But what of the costs?? Can society as a whole bear the costs of what many believe are entitlements?

He closed with the comment that somehow Main Street and Wall Street must have some sort of rapprochement.? If the two don’t work together, life will be tougher for both.

My final question was, “If you were to write a follow-up book, what would you write about?”

To my happy surprise, he is considering writing a follow-up book.? It is a book that would focus on risk management for the individual investor by looking through the windshield.? Keep moving on; embrace risk.? Develop processes that will help you embrace risk.? Spend more time thinking and less time slaving.

After that we had a bit of a discussion about liquidity, and how difficult it is to explain as well as how it can throw monkey wrenches into the best financial plans.? He felt that most problems from liquidity could be solved through business judgment, but that it would often cut across the short term goals of many financial firms.

What I have not captured in my comments here are the number of times that he emphasized how risk control must be a whole firm process, and how senior management must be committed to risk control.

To close this off, I will say that I found the interview refreshing.? David Martin has a very intelligent view of risk.? Risk must be embraced, but only at reasonable costs, and in view of decent returns.

So with that I once again recommend the book Risk and the Smart Investor. If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

Book Review: Risk and the Smart Investor

Posted on 25 September 2010 by David Merkel

Not every book grabs me at first.? “Risk and the Smart Investor” was one such book.? But it grew on me.? Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

I was fascinated with the structure of the book, which I found tedious and hokey at first, but I grew to like the intriguing and novel approach.? The author introduced the topic through his experience, then explained the theory, then showed how neglect of it led to failure, and then gave stories of Max and Rob, two very different men whose lives illustrated risk management, and the lack thereof.

Risk control has to be realistic.? You can’t eliminate all risks.? You shouldn’t even want to eliminate all risks.? Anyone who tries to eliminate all risk will end up killing the profitability the business.? As that great moral philosopher James Tiberius Kirk once said, “Risk is our business.”? (For the jobs were I was explicitly a risk manager, I kept that quote on my wall.)

I am going to touch on the themes of the book as I understand them.? In order to control risk, one must first be able to control himself.? Without self-control, there is no risk control.? That process requires humility.? Almost every action of risk control involves limiting the behavior of those that have the power to commit money for investment or to sell assets to raise cash.

Part of that comes down to understanding what are reasonable goals, and what aren’t.? Nothing grows without limit.? Almost every business has a maximum growth rate, which if exceeded materially raises the probability of insolvency.? This is true for individuals as well.? Peter Drucker once said something like, “Jobs should be big enough to be challenging, but not so big that they require superhuman effort.”? In the same way, efforts to grow your personal assets too quickly will lead to decisions with a high probability of large losses.

For risk control the context of large firm, the critical question is cultural issues.? That involves instilling the idea of risk control in every person if the firm ? making it a part of the firm DNA.? It must extend to the very pinnacle of management, and not let it be seen as something that is a tradable issue.? It is similar to the idea of a reputation.? You only get one reputation.? Your reputation is your brand.? If your reputation is harmed or destroyed, rebuilding it is desperately tough.? Granted, America is the land of unlimited second chances, but rebuilding is still tough.

We can diversify lines of business.? We can diversify assets.? We can diversify funding sources.? We can’t diversify our reputation.? We only have one reputation.? It is as one of my favorite bosses of the past said, “I’m willing to take lots of moderate risks, but not willing to take an action that has a material probability of destroying the firm.”? This is just another way to say that there are things that can be diversified and things that can’t.

Corporate culture cannot be diversified; it flows from the top and affects all employees.? Good risk control cultures inculcate checks and balances.? They make sure that no one has too much power, such that the work cannot be checked.? They insist on transparency within the firm and transparency outside to the degree that it facilitates business and satisfies regulators.

Such a corporate culture monitors continuously the factors that affect profitability future risks.? It also learns from mistakes, but keeps the risks small early in the process so that learning from mistakes is not an expensive and surprising endeavor.

The structure of the book contrasts financial risks and life risks through the lives of Rob and Max.? They are two very different people, one of whom is careful about risk, and one of whom ignores risk.? Just as we have seen firms that were careful about risk, during the present crisis, and firms that ignored risks, so we have seen the same in ourselves and our friends.? The stories of Rob and Max on the risks that we go through life and the risk that we go through markets.? In my opinion it richens the book a great deal.

Risk is inherent to life.? And, the ultimate risk is death.? You can’t diversify death.? You can’t pay a certain spread over LIBOR in order to engage to death swap on your own life.? The most you can do is build something that may last for some small to moderate amount of time after your death.? Even the great Warren Buffett is trying to do something like this, as I explained in my piece Moat, Float, Growth.

Quibbles

None.? It’s a really good book; very well-thought out.

Who would benefit from this book:

This book would benefit anybody who deals with the question of risk, whether personally or corporately, and that means all of us.? Not only do you get a lucid perspective on the causes of the financial crisis, but you get to see firsthand how corporations deliberately the word sound risk management principles in order to make money in the short term.

The reader also gains perspective on how to deal with risk in his or her own life.? Will you go the way of Rob, or will you go the way of Max?? Or, as most of us, will you do little of both?

I read lots of books on asset allocation, but relatively few books on risk control, because few accessible books get written on that topic.? This in my opinion was a very good book on risk control.? It has my highest recommendation.

If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.? It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.