Eric Falkenstein’s Finding Alpha

Monday, September 21st, 2009

Tyler Cowen definitely liked Eric Falkenstein's Finding Alpha:

It’s the best readable summary I know of why CAPM fails (see my comments here). Market data do not, upon examination, show a close connection between risk and return, at least not once you start moving out on the risk spectrum beyond T-Bills and the like. It’s not just the famous Fama and French papers, it is worse than you think. I also like the author’s “relative status” theory for why many people enjoy risk; it reminds me of Reuven Brenner, a neglected economist to this day.

Nonscientists Naive about Science

Friday, September 18th, 2009

Nonscientists are often naive about science, Eric Falkenstein says, even when they have great faith in it:

If you go to The Skeptic’s Guide to the Universe, you invariably hear a bunch of caricatures of those who disagree with conventional wisdom on science — most of which truly are quacks, but not always — and they pedantically emphasize how these alternative views are ‘not science’: they have beliefs that do not have peer-reviewed tests supporting a falsifiable hypothesis. Or listen to Chris Mooney, a journalists who thinks the masses are insufficiently scientific, and argues that Republicans hate or are ignorant of science. He argues we should have more ‘pro science’ candidates, reflecting the 19th century progressive notion that with education, most disagreements and bad policy disappears. Most importantly, if the masses knew more, he surely thinks then popular opinion would converge to his. This from a journalist, a clan whose scientific proficiency is similar to the athleticism of mathematicians.

When journalists talk about science in general this is usually a pretext for saying those who disagree with their favorite idea are wrong, because they are unscientific. Who can be against science? There isn’t a formal anti-science movement because it’s indefensible in principle. They then caricature their opponents, taking the most inarticulate advocates from the other side, and skewering their illogic. They then sit back and take take inordinate pride in their scientific pretensions, as if their selective discussion was objective. The fact is, most ‘big’ scientific issues do not conform to the scientific method, where one puts out testable hypotheses, rejecting ones that are falsified.
God is dead, but faith did not disappear. Rather, people always have faith in whatever they think is really important. With God out, now what is important is some big cause that, when fixed, will create a better world. As Eric Hoffer noted in The True Believer, ‘all mass movements are interchangeable’, meaning nationalistic, religious, social, political movements have the same true believers. Western civilization has tossed off nationalism and religion, but we are just as ideological as ever, only now we pride ourselves that our beliefs in social or ecological justice as the result of truth, divined through science. If only.

A Good Place to Start a Fight

Friday, September 11th, 2009

Eric Falkenstein discusses the politics of insincerity:

A major problem in politics is that it is not optimal for any party to say what they mean. People pound the table as to how innocuous a certain policy is, and how ‘crazy’ anyone must be to be against it. Others highlight a different endgame, a principle, or the insincerity of the policy. This is why Michael Kinsley famously said a ‘gaffe’ is when a politician accidentally says the truth. Ignorance, and bad faith, make truth-telling a dominated strategy.

It is important to distinguish between private and public sphere here, as in my private life I can adopt a truth-telling strategy because when I encounter the ignorant and those of bad faith, I can simply avoid those neighbors and friends going forward. In contrast, one must build coalitions in public, and one cannot simply abstain from interacting with such parties. Thus, insincerity is needed much more in public contacts than private contacts [one still needs some insincerity in private, like saying 'your butt doesn't look big in that' to your spouse].

Ignorant people will misinterpret your assertions or plans. The idea that getting rid of the minimum wage helps the poor or that giving people money to destroy old cars is a waste of money, is a complex assertion that takes an equilibrium argument, and is primarily theoretical. The benefits are seen and the costs are unseen. Alternatively, the idea that it is optimal for governments to have 5-year plans for industrial production at one time seemed obvious, based on the fact one plans before building a bridge. In this case, the error is not in undercounting the unseen, but a flawed analogy.

Then there are those with bad faith. Often these aren’t people out to get you, but rather, see your immediate aim as not in the best interest of their overall plan, and so want to stop it at all costs. Your failure is not their direct aim, but rather, consistent with their objective. Their opposition can be direct (‘no new taxes!), but it can also be indirect, helping the ignorant develop antipathy by clever caricature (‘he wants to hurt small businesses!’).

Thus, people often speak in metaphors based on principles no one is against. For example, in litigation, when asked ‘what is your endgame?’, an honest response would state one’s direct claim against the defendant. This would be a specific demand, but that presents a problem. Perhaps your endgame is something that an ignorant person would find highly dubious or self-serving if discovered. For example, you could merely want to effect a noncompete agreement, stifling a new competitor. Perhaps your endgame is costing your ex-employee a lot of money to signal to current employees the futility of trying to negotiate for more within the firm. Clearly, these are not sympathetic aims, even if your plan for crushing some plebes is part of a greater good via using your ultimate booty to fund a charity in Africa. So instead of saying something specific you say ‘to protect our intellectual property and enforce valid contracts’. You start broad, and when pressed, get less broad, but always keep at a level where any Sunday school teacher would agree with your goals.

In health care, I think the bottom line is that most people see this as a foot in the door to greater government control of a large segment of our economy, one that will be used for more egalitarian, and politicized, allocation of resources. Democrats in this country like egalitarian redistributions, and ‘politicized’ is just a pejorative for ‘democratized’. Republicans emphasize the inefficiencies of egalitarian distributions, the violations of liberty. As health care is expensive and already highly regulated, it’s sort of like the Balkans of historical Europe, a good place to start a fight on this more fundamental issue.

People Lie About Alpha

Friday, September 11th, 2009

If you take risks and make money, Eric Falkenstein notes, then, after the fact, everyone says that you took good risks, but if you take risks and lose money, well, you were just being foolish.

So people lie about alpha. They pretend that their returns from taking risks (beta-bets) are risk-adjusted returns (pure alpha). But then, it has long been the case that successful people are good at doing one thing while saying they are doing another:

Augustus Ceasar was successful because unlike Julius Ceasar he appeased the senators by making it seem like he restored the Republic (where the senate is in charge), when in practice he had probably more power than Julius Ceasar. When unions are successful they promote their agenda by appealing to how they are helping their customers, assiduously maintaining quality via their exclusionary rules. Affirmative Action was successful because proponents said it definitely does not imply quotas. The key is that many large strategies involve duplicity.

Things Never Change

Saturday, September 5th, 2009

Eric Falkenstein is reading a military and political history of Rome that he finds interesting and depressing, because it demonstrates that things never change:

All the dysfunctional diagnoses and remedies, leading to decline. You get the feeling society’s optimal sphere of military control was greater than its optimal governance size, making most of its last 5 centuries a disequilibria of waxing and waning coalitions and dynasties. I don’t think our politics is much better. Certainly, the best of the Romans are better than most modern politicians, but bit by bit they misunderstood what was sustainable, how to balance authority with sustainable power. Eventually it was no longer Holy, Roman, or an Empire.

What was most interesting was the part on how Romans needed to raise money, but had to resort to debasing the currency by decreasing the amount of silver in their money, which really took off in the third century AD. As prices rose they were totally flummoxed as to the cause, and blamed this on ‘greed’, a common enough political response in the twentieth century to excessive money growth. But fundamentally, there was no solution because the size of the Empire was larger than could be sustained, and monetizing the debt was a symptom of this problem. No politician gets power saying we should do less, the assumption is always that a state can achieve whatever it wants if it tries really really hard. Blaming symptoms we don’t like, such as greed and hubris, is a constant refrain. Some things never change.

Survivorship Bias and Austrian Business Cycle Theory

Friday, September 4th, 2009

Eric Falkentein shares his take on survivorship bias and Austrian business cycle theory:

When I was in charge of capital allocations at KeyCorp, I spoke with many of the business line managers, and was impressed by the fact that all of them had rather sterling track records, especially in the last recession. But I later figured this was all survivorship bias: the losers in the last recession lost their jobs. Thus, each thought they had some special alpha, special asset class, impervious to the mistakes of those who caused the big losses in the past. For a 45 year old who has never really screwed up it’s hard not to think this is the case, as opposed to merely the blind selection process of capitalism. This error is the fundamental genesis of business cycles, in my opinion.

In grad school, while learning macro, I would spend nights reading Austrian Business cycle theory, including von Mises’s Human Action (900+ pages!), and lots from Hayek. I was intrigued by the idea that business cycles were caused by a misallocation of resources, as opposed to merely ‘too much’ investment. That is, say you have 10% of the country’s resources in internet development, but discover the demand only wants 5%. All is fine as long as you don’t care about profits, look at sales/price ratios, but then eventually people get tired of not making money, someone says ‘the emperor has no clothes! There will never be profits’, and everyone stops investing in these areas. The transition from the old to new regime is only possible via firm failures and involuntary unemployment, because people don’t switch to new jobs until their old ones are gone, forcibly.

My only beef with the Austrians is that they emphasized the genesis of this missallocation via money creation, especially the fiat money creation of central banks and how this causes the interest rate to be ‘too low’, causing overinvestment in capital. This again gets into a straight aggregate overinvestment story, and that isn’t very empirically robust. I think to the extent there is overinvestment, it isn’t total investment nearly as much as in the wrong sectors. Today, that sector is housing, and finance.

Diversity is The Most Important Thing public schools teach

Thursday, September 3rd, 2009

Diversity is The Most Important Thing public schools teach, Eric Falkenstain laments:

In theory, diversity is about accepting people different than you; in practice diversity means those who ignore diversity have more moral clout. Thus, my kid’s schools do not have little birthday celebrations (eg, cupcakes) anymore because the new Somalis don’t celebrate birthdays, and we wouldn’t want to implicitly single them by having birthdays as was done for years. No one can mention this sucks in public, however, without being called in intolerant bigot, and as we all know, diversity is The Most Important Thing public schools teach.

Or a bunch of Hasidim move to a small town in Iowa to run a kosher meat packing plant (and hire illegal immigrants at $5/hour), avoiding the locals in their social activities and in schools, referring to them as shiksas and goyim, and the locals, not the new asocial group, needed to learn to ‘understand and respect each other’s differences’.

An institution that employs a bunch of autistic types is ‘diverse’, even though no individual who works there is accepting of diversity except management.

Thus, diversity is about acceptance when you are passive or ‘leading’, but for those who are not considerate about existing mores or who are doing, it’s a pretext for being insular.

Happiness in Modern America

Wednesday, September 2nd, 2009

Charles Murray was honored at the AEI a few months ago, and he gave a talk about happiness in the context of modern America:

His talk hit on an interesting paradox of welfare programs aimed at the poor, that it affects the satisfaction of life for those who are most likely to gain life satisfaction via non-vocational activities, such as faith, family, and community. Most liberals see faith as authoritarian delusions, and family and community needs the responsibility of the government. That’s not horrible if you have an interesting job you are proficient at, but if you are merely a hard working mensch, your paths to a meaningful and satisfying life are taken away.

In Murray’s words — but with my emphasis:

To become a source of deep satisfaction, a human activity has to meet some stringent requirements. It has to have been important (we don’t get deep satisfaction from trivial things). You have to have put a lot of effort into it (hence the cliché “nothing worth having comes easily”). And you have to have been responsible for the consequences.

There aren’t many activities in life that can satisfy those three requirements. Having been a good parent. That qualifies. A good marriage. That qualifies. Having been a good neighbor and good friend to those whose lives intersected with yours. That qualifies. And having been really good at something — good at something that drew the most from your abilities. That qualifies. Let me put it formally: If we ask what are the institutions through which human beings achieve deep satisfactions in life, the answer is that there are just four: family, community, vocation, and faith.
The sources of deep satisfactions are the same for janitors as for CEOs, and I also said that people needed to do important things with their lives. When the government takes the trouble out of being a spouse and parent, it doesn’t affect the sources of deep satisfaction for the CEO. Rather, it makes life difficult for the janitor. A man who is holding down a menial job and thereby supporting a wife and children is doing something authentically important with his life. He should take deep satisfaction from that, and be praised by his community for doing so. Think of all the phrases we used to have for it: “He is a man who pulls his own weight.” “He’s a good provider.” If that same man lives under a system that says that the children of the woman he sleeps with will be taken care of whether or not he contributes, then that status goes away. I am not describing some theoretical outcome. I am describing American neighborhoods where, once, working at a menial job to provide for his family made a man proud and gave him status in his community, and where now it doesn’t. I could give a half dozen other examples. Taking the trouble out of the stuff of life strips people — already has stripped people — of major ways in which human beings look back on their lives and say, “I made a difference.”

Fun Facts from Why We Make Mistakes

Tuesday, September 1st, 2009

Eric Falkenstein shares some fun facts from Why We Make Mistakes:

  • There is a 1 in 1 million chance of finding a gun in an airport check.
  • People don’t remember names, as opposed to the jobs or families of a person.
  • 80% of calls to a corporate help desk are for lost passwords.
  • Simply changing pill colors from white to red and black makes them more distinctive.
  • People recall their specific grades in school with an upward bias.
  • Men report a median of 7 sex partners, women 4.
  • 84% of doctors thought others were biased by self interest, whereas only 16% thought they were biased by self interest.
  • The most common airplane accident is ‘controlled flight into terrain’, or flying a plane into the ground.
  • When asked to pick a movie viewed later, more choose highbrow movies; choosing movies now we choose lowbrow movies.
  • Being first on the ballot adds about 3% to a candidates vote.
  • As something becomes familiar, the more we tend to notice it less.
  • We see things not as they are, but as they ought to be.
  • Experts make mistakes expecting patterns that aren’t there.
  • Depressed people are realists, happy people are overconfident.
  • People learn more from summaries than from reading entire chapters.
  • A horse race handicapper does as well with 5 bits of information as having 10, 20, or 40, though his confidence increases with the number of information bits available.
  • Hope impedes adaptation. Someone with a potentially reversible colonostemy is more unhappy after 1 year than someone with a 1 year irreversible colonostemy.
  • When you are trying to make judgments about complex systems, things that are easily observed are overweighted.
  • Money does not improve efficiency of large organizations (ie, giving everyone more money).
  • Money does increase the ability of individuals to withstand discomfort in tests.

Why Democrats Tend to be More Socially Liberal

Sunday, August 30th, 2009

Eric Falkenstein, who is socially liberal and fiscally conservative — that is, libertarian — offers a tenuous explanation for why Democrats tend to be more socially liberal, given their high-tax ways:

Before the modern personal income tax in 1913, liquor taxes accounted for about a third of federal revenues. Then came the income tax in 1914 and, on its heels, America’s entry into World War I. During the war federal revenues received through income taxation for the first time exceeded those from any other single source. By fall of 1917 Congress saw the income tax as its chief source of revenue, reducing the cost of voting for Prohibition in December 1917.

The Great Depression severely depressed incomes and tax revenues correspondingly plunged beginning in 1931. By 1932 federal income-tax receipts fell by well over a third from their level in 1931 and to almost half their 1930 level. Prohibition’s repeal in 1933 generated a big jump in revenues. As a percentage of federal government revenues, liquor taxes jumped from 2 percent in 1933 to 9 percent in 1934 to 13 percent in 1936.

Big government fans need money, and income tax revenues do face a Laffer curve effect at some rate. In this context, taxing underground activities is a no-brainer for most Liberals, and so big-government types are in favor of legalizing activities that conservatives think are best kept underground.

It looks like there’s a lot of money in legalizing marijuana.

The Law of Unintended Consequences

Saturday, August 29th, 2009

Eric Falkenstein shares some examples of The Law of Unintended Consequences:

Solar Panels: Just yesterday I read about nitrogen trifluoride, one of several gases used during the manufacture thin-film photovoltaic cells and flat screen TVs. Many industries have used the gas in recent years as an alternative to fluorocarbons, and of course building photovoltaic cells is part of solar energy. Unfortunately, the gas is 17,000 times more potent as a global warming agent than a similar mass of carbon dioxide. It survives in the atmosphere about five times longer than carbon dioxide. The net result, in other words, is more greenhouse gas than using standard fluorocarbons.

Pesticides: Plants have many natural toxins designed to protect themselves against herbivores. Celery defends itself by producing psoralen, a toxin that can damage DNA and tissue and also causes extreme sensitivity to sunlight in humans. People who handle celery professionally often develop skin issues: if it were man-made, it would be banned. Celery psoralen production is highest when it feels under attack, as bruised stalks of celery can have 100 times the amount of psoralen of untouched stocks. Farmers who use synthetic pesticides, while creating other problems, are protecting plants from attack. Organic farmers don’t use pesticides, but this leads to stalks becoming vulnerable to attack by insect and fungi, and when those stalk are munched on by the little critters they respond by producing massive amounts of psoralen. Pick your poison.

Saving the S&Ls in 1982: When interest rates were 18% in the early 1980′s, most S&L’s were insolvent, so a simple off-balance-sheet solution was to give these highly regulated institutions more powers (Garn-St.Germain) and increase the amount of deposit insurance from the Federal Government. Only six years later, there was a Savings and Loan crisis, the failure of 2412 S&Ls in the United States. The ultimate cost of the crisis is estimated to have totaled around $560 billion, about $320 billion of which was directly paid for by the U.S. government. This is the archetype of ‘moral hazard’, because those depositors who might have monitored these risky actions had no incentive, and the managers basically had a free option to swing for the fences, which they did.

I fully expect the latest legislation to create a disaster in 5-10 years.

Why ‘Leaders’ Aren’t Smart

Friday, August 28th, 2009

When she was on Letterman, Tina Fey diplomatically questioned Sarah Palin’s intelligence:

I see her and think she’s as smart as I am. I want someone smarter than that in the White House.

Eric Falkenstein considers it naive to expect smart leaders:

If you have an IQ above, say, 130, you can’t mouth the inconsistent platitudes with sufficient sincerity to be elected leader. That is, a really smart person can’t in good conscience say that ‘giving to the United Way is the most important thing we do here at Amalgamated Financial’, or that you listen to each customer suggestion on various product releases. It’s BS, but the troops need to hear it, so they get the only people who actually can champion such inconsistent policies. Both Obama and McCain are overselling a load of policies that won’t change much, except for the new government bureacrats in charge (as opposed to the people they are supposed to help), but that ‘not-so-bright’ mindset was necessary to win their party’s nomination. Someone with a painful sense of the obvious and inconsistent, would be seen as not sufficiently inspiring to the masses, as I’m sure he would not be. So we give the people what they want, good and hard.

Humans live in a ‘reverse dominance hierarchy’, so that a leader too dominant, not sufficiently deferential, will not be chosen to lead. Humans hate hubris in their leaders more than anything else, and so a smart guy, who can’t fake appreciating the vastly more numerous pedestrian managers out there, will not get enough support. Anyone with a sufficiently high IQ, to be consciously faking there enthusiasm for the pap they are pushing, is so evil they are much worse. Thus, be happy with the stupid 125 IQ guys, it’s as good as it’s gonna get. The exceptions you see, mainly, are really smart founders who often created their product.

Resilient to Criticism

Thursday, August 27th, 2009

The larger the system, the more resilient it is to criticism of any sort, Eric Falkenstein argues:

If the system is successful, in terms of shuttle flights or mortgage default rates, it doesn’t matter what your ‘theory’ is as to why certain risks are too great — these risks will be explained away because in any complex system, the theory as to how one thing affects the entire system is tenuous. There are too many interest groups benefiting from the systems current state, and they will find good reason to dismiss concerns as evidence of envy, selfish interest, ideology or muck-raking sensationalism. The larger the system, the more resilient it is to criticism of any sort.

A good current example of a trend that cannot continue, yet there is no data against it, is government debt. While the official debt-to-GDP ratio is manageable, about 26th or so worldwide. But the off-balance sheet liabilities, thing like Medicaid, Social Security, increase our debt 5 fold (to around $60 trillion, compared to on-balance sheet debt of 10 trillion.). Ever since the passage of the unified budget act during the Nixon administration, the government has had the privilege of spending the Social Security funds by transferring the money into the general fund, from which Congress can spend on whatever pork projects they wish.

Many government entities, city and state, keep increasing their off-balance sheet liabilities at a rate that implies preposterous tax rates or reneging on promises, but no one worries because this has been going on for a while. You would go to jail if you did this in the private sector, yet it is OK because it seems to work.

Stein’s law states that trends that can not continue, won’t, which implies the government will either have to default, reneg on benefits, or pressure the Fed to inflate. Those noting this risk of this strategy have been proven wrong by absence of any failure in this area. When the future budget crisis hits in this area, it will dwarf our current crisis by a factor of 10.

I don’t see how the risk of a complex system can be correctly calibrated without massive failure, because there are just too many incentives to rationalize risks as being under control as long as the system is working, and so it just continues until failure. They are an endogenous risks to our system, so the economy will never achieve a steady state, which given over a hundred years of business cycles, is a pretty safe forecast. The bigger question is, in my mind, is why don’t large systems fail more often. That is, the average annual corporate default rate in the US is around 1.4%, over good and bad times, which is pretty low.

Why Cash Flow Works

Wednesday, August 26th, 2009

Most bad business models will go on until the cash runs out, Eric Falkenstein notes:

That’s why cash flow is a useful predictor, because money losers keep losing money, and driving the stock down, until it goes to zero. Sort of like GM’s strategy.

This is basically foreshadowed by Warren Buffet (p. 85 Investor’s Anthology), when he wrote these common company foibles:

  1. An institution will resist any change in its current direction;
  2. Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;
  3. Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategy studies prepared by his troops; and
  4. The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Global Warming Not About Science?

Tuesday, August 25th, 2009

Erik Falkenstein remarks that the UK’s Minister for Europe was surprised to learn that some Americans thought climate change was a pretext for a liberal agenda:

I guess the idea never occurred to him because as Al Gore noted, the science is over.

He noted that the upside of Global Warming is there are tons of ‘green collar’ jobs to be had! And he has a point. If we don’t let companies burn fossil fuels like coal or gas, and don’t build any more nuclear plants, all of us will have full time jobs collecting biomass for fuel as they do in Africa, or washing our clothes in the river, or walking to work. The smell of dung can really add a little zest to your smoked ribs.

Living in Minnesota, we could use a couple more degrees. Indeed, cold spells are generally worse for mammalian life than heat spells, but that’s no mind. The reason why some of us think there’s a pretext here is we have heard many similar warnings about the acid rain, Carter’s malaise speech about the 70′s energy crisis, the ozone hole, deforestation, and then when the metrics don’t continue their trend and life goes on, they find a new boogie man. There’s always a greater good, whether it’s not discussing the gulag when coming back from the Soviet Union, exaggerating the risk of heterosexual AIDS, downplaying the corruption by the latest African kleptocrat, or promoting the “4 food groups”, many, if not most ‘big ideas’ are merely pretexts for people wanting to push various selfish agendas.