I remember the story about Solomon to whom God offered the choice of either great wisdom or great wealth. As we all know, he selected wisdom. When God granted his wish, Solomon reportedly slapped his forehead and exclaimed, “I should have taken the money.” Oh well.
Though I had read Against the Gods: The Remarkable Story of Risk and When Genius Failed: The Rise and Fall of Long-Term Capital Management, I underestimated the impact of the fat probability tails. Trained as an engineer, I am facile with Gaussian or “Normal” distributions, stationary processes, correlations, linear systems, and so forth. This is knowledge is backed not just by training, but also by personal real-world experience over decades. I have lead teams that built some fantastically complex electro-opto-mechanical machines. It seemed a miracle that they worked, but they did and were manufacturable. They wouldn’t have stood a chance if the physical world in which engineers live had fat tails.
On the other hand, I have worked a lot with people. Unless you care about their weight or height, the affairs of men and women are decidedly not Normal. I also have personal experience here. As a General Manager and later as a Group VP, I confronted volumes of real-world data on Bookings and, frustratingly, on project delays. I tried to apply the statistics I knew to these data. They emphatically did not fit. There were many too many outliers. As I read Taleb’s book at the end of 2008 on The Black Swan: The Impact of the Highly Improbable, I could see his assertions in my own data. Gauss must have had great marketing to have his distribution called “Normal.”
But I did not take black swan events into my portfolio planning. 2008 was The Year of the Black Swan. Or more correctly, it was Yet Another Year of the Black Swan. On Black Monday in 1987, I was on a plane taking my family to Japan for a year. A little over a decade later I was in Silicon Valley for the bursting of the irrationally exuberant Internet Bubble. If I live long enough, I will see several more Years of the Black Swan. [2022 update, oh yes indeed!] These one-in-a-million events seem to be occurring about every 10 years.
I just gave my carefully-read book on VAR to Goodwill. This qualifies as a tax deduction, but I am not sure it qualifies as a good deed. I like Eric Dinallo’s comment that it is important to know what questions one can and cannot ask a model. One cannot ask VAR whether or not we are in a speculative bubble. Greenspan prophesized the Internet Bubble but not the Sub-prime Bubble. Bubbles are difficult to call.
The 2008 problem was heralded, as usual, by numerous signals. Certainly there were people who predicted this event. Monkeys typing Shakespear? Butterfly wings flapping. Maybe. Maybe not. Brilliant people predicted doom. Other brilliant people forecast cornucopia. Doesn’t matter. There are too many signals and the system is too complex. I was not being sufficiently paranoid.
But there were dark clouds so I started listening to financial and economics podcasts. (What I should have done was flee the stock market.) Fascinating. Will the dollar go up or will it go down? Lot’s of compelling sounding arguments on both sides of the trade. One side wrong. I finally had the epiphany that in a liquid market, there will always be convincing-sounding arguments on both sides of the trade or, of course, the market price would be different. It may be impossible to listen to the experts and figure out who is going to be right over the short term. It might as well be random. Maybe the long term is different, but then again Keynes said that Mr. Market can stay irrational a lot longer than you can stay solvent. I have shifted my focus to listening for bullshit. My career has given me a pretty good bullshit detector and the herd clearly has moments when it is believing some things that pin my b.s. detector. For instance, there was a commonly spouted theory about “decoupling” that said that even though US consumers have stopped spending, the Tigers would be unaffected. I made some money shorting EEM.
But I generally did this sort of investing with “play money.” For my real nest egg I depended on professionals. I am a professional scientist and engineer. In areas in which I am an expert, I am much much better than the average college graduate. Engineering school graduates are, in aggregate, much much better at engineering than the average layman. But the data do not say that this is true for financial experts picking stocks. Perhaps some financial experts are indeed much better, but how do I tell them from lucky monkeys taking big risks with other people’s money? Lucky monkey. Unlucky banana.
I have found only one way to invest in individual stocks that really works for me. It is to invest in industries that I know very well. There I go long on the CEO and team that I respect and short the CEO and team that I feel are clowns. This doesn’t come up often, but I look for it. I am sure I will meet a black swan in this pond one of these days, but so far this has worked for me flawlessly. But again, my bets here have been more of a size to entertain than to enrich. I tend to doublethink it too much by believing that all public information is already in the market so the fact that one CEO is competent and that the other is not is already in the price. But the market is clearly not this efficient. You can indeed fool all of the people some of the time.
Which bring us to diversification. Obviously, the industry I know the best is the one I am working in. The experts say that therefore I need to diversify out of that area into areas about which I know little. Wonderful, for them. But diversification does have value. Say you invested all of your wealth in a fund-of-fund [sic] that was 100% invested in Madoff. Remember Enron. Remember WorldCom. Remember the Alamo. And the perpetrators of massive wealth destruction don’t even need to be crooked, though clearly it helps. Clearly not having more than 5% of your eggs in such a basket is prudent. But as for the usual argument for diversification among asset classes, there seems less than meets the eye. If you invest for the long term, the fact that bonds went up during a segment of time when stocks were going down did little for you because you presumably averaged over many up and down time segments anyhow. And as for protecting from black swan events, forget it. Asset class diversification mostly won’t help. Most asset classes tanked together in 2008, except commodities such as oil which shot the moon and then cratered. In addition to the usual problems, hedge funds now create massive invisible correlations among seemly-uncorrelated asset classes. These come about in part because of leverage and margin calls. My revised portfolio theory says diversify to protect from the masterful crook and the breathtakingly incompetent manager. As for investing in areas in which I also make my living, I am resolved to continue to do so with even larger bets but to be about as long as I am short.
There are a lot of reckless monkeys out there investing other people’s money. As a rule, financial monkeys have asymmetric compensation schemes that reward high returns more then they punish poor performance. Given this nonlinear objective function, if you sum over the whole population, the ensemble maximizes its total return by taking maximum risk with your banana. After decades of management, I have come to the deep conclusion that people generally do what you pay them to do. Today we incentivize money managers to take excessive risk while telling them to keep our money safe. Guess how this story ends. Neither children or money managers listen to what you say, they only pay attention to what you do. To make matters more exciting, we also reward money managers for engineering a bigger disaster the day after tomorrow rather than a smaller blow up tomorrow. All disasters are more or less equivalently bad for the financial professional so we encourage the smartest money managers to risk ruinous disaster in the longer term for good returns in the near term. Sound familiar? Indeed, by this measure, the Ponzi scheme is an ideal strategy. With apologies to Cyndi Lauper, “Bankers just wanna have Bonuses.” By the way, we do the same thing with politicians, which is why Social Security is the world’s largest Ponzi-Madoff scheme.
Are markets efficient? Rational? In undergraduate physics courses we laughed about mechanics problems so idealized that you would get homework sets like “. . .a massless elephant on a semi-infinite frictionless plane. . .” Good for teaching basic physics, but not a very high fidelity model of the real world. They say that Mr. Market is a manic-depressive. From irrational exuberance to hungover gloom. The market may always be right in an existential sense, but it does not obey laws we understand. Moreover, I don’t believe it obeys laws we can ever understand. And the irony is that the more we study the market and the deeper our understanding becomes, the more the dynamics adapt to confound us. As soon as a consensus emerges on a behavior, then in that knowing it ceases to be a basis of trade and thus becomes irrelevant. Other murky things emerge to move the market in its place. I’m thankful that gravity doesn’t work that way! When reduced to trading goods one could argue for a rational and comprehensible basis for the market because different goods actually have different value to different people. But when we have abstracted it all to money, how can we argue that money is of different utility to different people? When we are all trading money, risk, and interest in assets we have no intention of actually consuming or touching, it has become a game. Money is worth only what we all agree it’s worth. Alas, we have all agreed to be significantly poorer.
Sadly, I don’t think that the lessons I have learned this year about finance have been worth what I have paid for them, but lessons in humility have that depressing character. To those whom God will lie low he first gives a bull market.
In 2001 I saw bumper stickers on cars in Silicon Valley that begged, “Please, just one more bubble.” As my old boss said, “Be careful what you ask for.”