Monday, May 26, 2014

Three Points On Knowledge

1. Over Representation:

Think about when we offer our knowledge and opinions (and conjectures) on a particular topic for which we are not an expert--in other words, 99% of our daily dialogue. It would be interesting if the social norm would be to conclude by saying, "And that is the extent of my knowledge on this subject." Some people, of which I am one, are of the personality type that they feel compelled to share everything they know about a subject when discussing it. There is nothing wrong with this per se, but it can create the false illusion that we know more than we actually do--that there are even more gems left in the bag rather than that's all, folks!

I've been trying to make an effort to be more explicit about the limits of what I know, and I plan to work harder to that end.

2. "I Don't Know"

"I don't know"* is the almost always unacceptable response that is almost always the most correct answer. What happens after we die? There is but one correct answer scientifically speaking. You can believe one thing or another, but you do not know. 

IDK is nearly as applicable to all questions pre death. The complexity of our Universe, our economy, our own preferences leaves us generally in a state of darkness with just flickers of sporadic light. We should be more appreciative of this truth.

Yet humans have a universal thirst for certainty. Inquiring minds want to know. That is a good thing--it leads us to question and find answers and then question those answers to reveal deeper truths. I just wish we could be more honest about how true and virtuous the answer IDK is. If we were, it might minimize how thirst for certainty is also a bad thing. It is a big part of why we crave and succumb to authority. It is how con men can win over intelligent people. The investment community if full of people who refuse to say IDK. Politicians get roundly "defeated" in debates by even hinting at IDK. In business you might as well say "Fire me now".

Saying "I don't know" takes courage and wisdom, and so does acceptance of it as an answer.

3. Trust of Knowledge.

There are two extremes along the dimension of trust I am considering here. Those extremes are only trusting locals vs. locals are morons. I think people tend to fall toward one extreme or another, but they are not consistently at either end. Rather it varies topic to topic. The former extreme is driven by belief that only locals understand the circumstances whereas the latter is driven by knowing locals too well to know their flaws. Both reasoning are obviously faulty when at the extreme.

I see this thinking often in my profession, investment management. Some people are biased against a local firm managing their money preferring at least someone "smart" enough to be in Dallas or Chicago if not New York. Other people take the opposite approach and are very fearful of anyone from New York City! because "they will", of course, rob you blind.

Related (perhaps a bonus knowledge point): Margins of accepted error--how one's biases influence the margin of error one allows for cohorts who match versus cohorts who oppose one's views. Most ideas are bad ideas--impractical, plagued by substantially bad facts, and suffering from poor reasoning. Yet I think we cut our ideological brethren a lot of slack while being harshly critical of our opponents. We do something similar in business. If I trust locals, I give them a wider berth (and perhaps more financial leniency) than I do outsiders. If I think locals are fools, the hurdles I make them clear leave both of us poorer.

There are many ways we inconsistently apply margins of accepted error. Recognition and mitigation of these requires constant vigilance.

Keep thinking . . .

*There was a recent Freakonomics podcast on IDK. I thought it was good, not great. I hope the space they devote in their new book is a little more fulfilling.

Sunday, May 25, 2014

Highly Linkable

Two short videos lead us off. Work is a means not an ends. The world we live in is wonderful; be happy.

I want to go to there.

I want to go to then.

Tradesports is back, baby. Can't keep a good man down for long it seems.

I'd like for us to think hard for a moment about hard-boiled eggs. Next, please quit trying to make me feel guilty about foie gras.

Turning now to the item du jure in economics: Thomas Piketty's "Capital in the Twenty-First Century". There will be more soon, much more (including something about how, oops eeps, looks like his data may have had spreadsheet issues). For now just a few points with which I heartily agree: Landsburg says income inequality is something to celebrate. Cass Sunstein takes an Alfred E. Neuman approach to the issues Piketty raises (note, I do NOT heartily agree with the FDR conclusion at the bottom of the piece). But let me recast Sunstein's argument a little more clearly.

For those who reflexively agree with Piketty’s worldview, a question.

In which world would you rather live:

  1. A world (starting from where we are today) in which the rich however defined (e.g., top 5%, top 1%, top .01%) see their wealth grow at 5% per year while the rest of society sees its wealth grow at 2% per year, or
  2. A world (starting from where we are today) in which everyone sees their wealth grow at 1% per year?

How you answer this question says a lot about how personal envy ranks for you versus your love for others. I am not saying this is the choice we face. I am saying if it were, which would you choose?

Russ Roberts offers a great, short lesson in economics specifically regarding GDP and government expenditure. A snippet:
Here's the fallacy. Suppose I want to know your income for the year. I ask you and you tell me you made $50,000 in salary. Another way I can get to that number is to add up everything you spent money on--food, rent, clothing, entertainment, savings and so on. As long as I count everything, I get to the same number, $50,000.
Suppose I find out you spent $5000 on entertainment. It would be very wrong to say that without that spending, your income would only have been $45,000.
Read and understand this post from Scott Sumner, and you will have a better grasp on current monetary macroeconomics than quite a large portion of the economics-commentary professional class.

Climate Alert! A really small change might happen to the Earth in 100 years. So, panic now? No.

Scott Lincicome at Cato discusses two trade policies that make domestic gasoline prices higher than they would otherwise be.

Here is a sports-statistics lesson applicable and important in a wide range of fields from medicine to business: "...the complexity of a stat should not be its selling point. If a stat tells you something, but you can't act on it, it's no good." read the whole thing.

Not good at investing? Blame your caveman ancestors. Hint: Your problem is you don't and are not built to understand risk well.

Information technology and networks are all busted (HT: Barry Ritholtz). Have a nice day . . . for the record, I'm not as jaded and pessimistic as this piece, but I think there is much truth here.

Thursday, May 22, 2014

This Post Is Brought To You By The Number 3

My friend George has a theory. It is a sound theory with which it is hard to argue. He says the right number of kids is two. Two makes sense, he says. Two kids makes a foursome: great for golf, easy to seat at a restaurant, comfortable to ride in the car, etc.  Two kids means it is easy for them to have their own rooms. Easy to park their cars in the driveway as they get older. 

His kids are now grown and off on their own. I think he is happy as well he should be with the choice he and his wife made. I can find no argument to make with his points. While there is evidence and argument to say he might have been happier if had crossed one more bridge, I have to agree it has worked out well for him and his family. 

All I can say is this (after the jump):

Sunday, May 11, 2014

Adding Value to Investment Management

I've clumsily touched on this before.

I believe active investment management (e.g., being a stock picker who is aiming to outperform the market) is actually just a proxy for risk exposure--dialing up or down one's exposure to market risk. Consider the market price discovery process as a game whereby success is rewarded, poor performance is punished, and market knowledge increases even if average participant knowledge and skill does not.

For example, consider people betting on football games. The bets placed are on which team will win and by how many points in a given matchup. As people make their guesses over the course of many games and over time, the good guessers are rewarded with more resources while the bad guessers are punished encouraging or forcing them to exit the market. The average guess is the market price, the best estimate of future results. The market's knowledge increases along two dimensions: as more people make guesses, more information is incorporated into the price; additionally, as results come in, the better guessers dominate the guessing. This is a simple illustration of the wisdom of crowds. Yet as a new participant starts making guesses, there is no way to know what his guesses will look like or if they will be more accurate than the average guess. Paradoxically, these new guesses will very likely be less accurate than the market's estimates but their addition to the market will add to the market's accuracy. How does this paradox hold?

Imagine the market estimate is for OU to beat Texas by 10 points. A new bettor comes into the market betting that OU will beat Texas by 17 points. Let's assume that subsequently the market estimate adjusts to OU will beat Texas by 11 points. OU then does beat Texas by 12 points. The market was more accurate than the new guesser, but the new guesser improved the market's accuracy. I contend the specifics of this example are a good representation of new information incorporated into the market. It didn't have to be that the new guesser was less accurate and still accretive to the market estimate. To be clear that is my argument.

Thus, the market price is a random walk (we can't predict the direction or magnitude of the next change in price) with a drift--a drift towards greater accuracy. Active managers are attempting to be smarter than the market. However, the market is pretty darn smart, like +99% smart--meaning that is how close the market generally gets to accuracy (being as accurate as one could be at a given point in time). How confident are we these managers can add to that and why would we think they could, over time, across hundreds of securities at any one point in time? Even if there is a persistent flow of "dumb money" flowing in to the system, why should these managers be in any position to consistently pluck it off? It is very doubtful they would be, and if they were, why is the dumb money so willing to put itself in such a position? We can tell stories here to hypothesize about why, but inherently there is a tension between those stories and the underlying market process that makes those stories necessary--if the market is getting smarter, then the new money must be getting dumber to allow for smart money to be smart (i.e., smarter than the market). But then how can the market be getting smarter???

Active management is risky arbitrage at best. Here is what I mean: imagine I see that the price of rice in Japan is $550 per ton while the price in the U.S. is only $450 per ton and total shipping costs average about $50 per ton. A riskless arbitrage would be if I could instantly buy rice in the U.S. market and sell rice in the Japanese market at the prevailing prices less the shipping cost. Let's say I explore that option but find it is not available. The next best thing is to physically buy rice in the U.S., rent a ship, steam over to Japan, sell the rice . . . then . . . profit. Turns out when I get there they won't let me sell it. Or they will let me sell it but only with a hefty $100 per ton tariff charge. Oh, and the ship might sink before I get there. What I have engaged in is a risky arbitrage. My ignorance of Japanese tariffs or my bad fortune on the high seas means my attempts to beat the market on pricing rice were in vain.

I was operating somewhat in the dark in my rice arbitrage, and more knowledge would have been helpful. Alas, overwhelmingly most knowledge is hidden. Market participants, even the brilliant ones, can never be certain they even have the sign on the price discrepancy right. To wit from our analogy, the price of rice in Japan might be LOWER than the world price once all opportunity costs including risk are considered.

This puts active management in a new light. It isn't an attempt to deliver above-market returns. It is an attempt to deliver more risky or less risky market performance--it could be either case depending on the manager. Modern portfolio theory simplifies the world and says investors achieve this by borrowing or lending at the risk-free rate and then increasing or decreasing respectively their exposure to THE market portfolio. Perhaps active management is a real-world facilitator to achieve these ends.

Saturday, May 10, 2014

Highly Linkable

Last Saturday, May 3rd, saw the passing of a giant in economics, Gary Becker. Becker was one of the first economists I got a regular exposure to via his column in BusinessWeek. I immediately found an intellectual home in his economic wisdom. David Henderson memorializes Becker here. Russ Roberts remembers him here. Cass Sunstein reflects here.

Assuming the standard arbitrary delineation of the economy into parts, there is perhaps now a new "largest" one.

Josh Barro puzzles over why anyone would want to be a homeowner. Steven Landsburg offers a good critique of Barro and a valuable overview of the issues involved. Megan McArdle counters to a slight degree. With a nod to Arnold Kling, there are major problems with leveraged homeownership as the primary middle-class asset: owning an asset that by its nature is depreciating--try as you might to fight the tide via HOAs and monitoring city council meetings, at the end of the day you're planting flowers as the local factory closes. King Canute could relate as the former actions are immaterial relative to the latter, exogenous, effects. And the latter doesn't have to be a local economic shock like a major employer leaving town. That is just a stand in for depreciation in general. There are two forms of depreciation: wear and tear and out dating. As you perfect taking care of the former, you risk maximizing the latter. At some point you have completely rebuilt an outdated house or you have chosen an expensive way and place to build a house brand new--an interesting spin on the Ship of Theseus paradox.

On a related personal note, I have two friends about to realize a big dose of depreciation in similar ways. One is going to nearly fully replace his heat/air system and the other is going to fully replace both sides of his two-unit heat/air system. The first is looking at about $5,000 in cost while the second will see about $13,000 in cost. All that just to get back to even so to speak--nothing different to show for the huge purchases.

Caplan is playing matchmaker between Western Civ and Open Borders.

Jeffrey Tucker says P2P will prove to be a death blow to the state.

Questioning the conventional wisdom in two examples: (1) saturated fat does not or at least may not cause heart disease, and (2) race perhaps is genetic and is not a social construct.

Humanity has officially jumped the shark. Of course, we knew Las Vegas would be in on it.

Sunday, May 4, 2014

Highly Linkable

Into the caves

Out on the shore

If you're looking for poetry, look elsemore.

Sumner illuminates the thing versus the thing that is done.

In Europe silver spoons aren't just a good idea, they're the law! Is a world of Ricky Stratton's really the progressive dream?

Insider trading as a parallel to prohibition.

It's Derby time; hence, it is julep time.

Thursday, May 1, 2014

Football vs Basketball vs Soccer

Indulge me for a moment while I think a bit about the differences between these sports.

While there are plenty of fans of all three of these sports, I'm interested in thinking about why some people are strong fans of one or two but not all three. I believe quite a few people fit into this interest group. What about baseball and hockey? We'll get to that in a moment. Personally, I find football fascinating, basketball highly interesting, and soccer mildly entertaining. Wondering why got me to thinking . . .

I believe varying appreciation for these three sports ultimately comes down to a different appreciation for the marginal score--that is, the incremental or additional score. Soccer scoring is too infrequent to produce a sufficiently large enough fan interest from the marginal score alone. If you're watching soccer, it must be for more than just the occasional scoring. Basketball is on the opposite end of the spectrum where scoring is too frequent to produce a sufficiently large enough fan interest. If you're watching basketball, you must be watching it for more than just the frequent scoring. Football is in the middle where the marginal score all by itself becomes a sufficiently large driver of interest.

For these reasons we have support for soccer being called "The Beautiful Game". In basketball on the other hand fans are not looking for the marginal score; instead they're looking for the sensational score. So in a given game whether there are few points scored or many, points won't be the driver of how interesting it is the typical fan. The driver will be how many sensational plays there are from dunks to three-pointers to amazing assists. In football virtually every scoring play is an amazing sensational play. Soccer shares this quality except soccer has way too few points scored.

So, one's appreciation for each sport will relate to how one values marginal scoring--the more one values a marginal score, looks forward to the actual next score to take place, the more one will enjoy football since it offers the most value from scoring itself. As one fades from that peak, it depends on what else they look for to enjoy spectating. If one values more the flow and the back and forth of the game, one is more attracted to soccer. If one values more the impact and style of actually scoring, one leans toward basketball. Looked at this way I see golf and baseball very much like football. I see hockey (obviously, 'soccer on ice') very much like soccer as are gymnastics and wrestling. I see boxing and tennis very much like basketball (think punches equaling baskets made). More parallels could be drawn. Looking at my interest personally shows the limits of this theory. I definitely like basketball more than baseball or golf even though the latter two's close cousin, football, is king for me; so there is surely more going on to determine who is a fan of what. And I am not forgetting that some people are strong fans of all three football, basketball, and soccer.

Remember that my major implication is what type of fan is attracted to each of the three sports. It's why basketball fans may find soccer boring and soccer fans may find basketball redundant. Soccer games are usually not as close as the score would seem to indicate, and basketball fans find this particularly confusing. A lead in basketball is usually not as secure as it would seem, and for this soccer fans are confused. A football game can have nothing sensational leaving basketball fans wanting. On the other hand a football game can be filled with plays that make it seem that one team is throwing the contest. These games with too easy of scoring leave soccer fans wanting.

PS. I don't know and I don't care where Quidditch falls in this analysis.