Buyback Brouhaha

Optionally Not Good

Share buybacks tend to divide investors between those who love them and those who positively abhor them. The latter tend to come with the view that finding and holding stocks that offer outstanding long-term returns is hard enough without managements surrendering that value in order to artificially boost stock prices.

It turns out that company managements are generally very keen on stock buybacks because they’re linked rather closely to executive remuneration schemes and, in particular, the scourge of all investors everywhere – executive stock options. Nearly everywhere you find significant buybacks you also find large scale stock option schemes and as managements take away from shareholders with one hand they reward themselves with the other. Nice work if you can get it.

The Logic of Share Repurchases

Share buybacks or repurchases occur when a company either goes into the market to buy its own stock or tenders for it, off market. The shares are taken out of circulation and the earnings-per-share of the company goes up – same earnings, less shares. As a shareholder you might well think that this is a good deal – and it may be, but it isn’t always. Often, isn’t.

Although short term earnings per share goes up – and the share price will generally follow to keep the price-earnings ratio stable – the company is, in fact, investing its precious earnings in non-producing assets. The whole idea of a corporation is that it takes its excess earnings – its profits – and invests them to generate growth in future and, therefore, increase earnings. These higher earnings, if no more stock is issued, will automatically and organically generate higher earnings per share and share prices.

Future Earnings Failures

If, however, the company spends its excess earnings on its own stock it’s not investing in its future. Occasionally this may be a valid thing to do – if the company is trading at a very low price in relation to its real value and it has excess cash that it can’t deploy for one reason or another then it makes sense to engage in buybacks because this is rewarding long-term shareholders, who will end up with more real assets for their money, over short-term shareholders, who will be selling out. Of course, these aren’t characteristics common to the modern corporation.

As usual Warren Buffett said it best. Back in the 1999 Berkshire Hathaway annual shareholder’s letter he waxed large on stock repurchases:

“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.”

The point is that if a company is selling in the market below its intrinsic value (see Is Intrinsic Value Real?) and it has the free cash available to make repurchases then stock buybacks make sense. Otherwise they don’t – buying shares in the market at more than they’re really worth makes no business sense whatsoever. It punishes long-term shareholders whose earnings are being deployed in a value destroying way.

In fact the only people who benefit from such actions are those who are intending to sell in the very near future, who are likely to get the artificial boost of a rise in the share price. Given that those people who want to exit the shareholder register should be near the bottom of management’s interests and the fact that most buybacks tend to happen at prices in excess of intrinsic value this suggests that there’s something odd going on.

Management Logic?

There are multiple possibilities as to why managements might behave in this manner. One, perfectly straightforward reason, is that they’re probably not very good at figuring out the intrinsic value of the company they’re responsible for the stewardship of. At the best of times this is a difficult calculation and in some industries it’s simply impossible because the lack of forward visibility shrouds any reasonable estimates in billowing clouds of uncertainty. In fairness managers are paid to manage, not to constantly figure out the real worth of their company. It’s just a shame they often can’t do either.

It’s also a curious anomaly that repurchases are common when stockmarkets are flying high and stocks highly valued and rare when they’re not. Again, possibly, there’s a rational reason for this – in times when stockmarkets are doing well management may feel particularly, if irrationally, confident in the future and feel obliged to find a way of deploying earnings rather than simply putting the cash in an interest bearing account somewhere. In any case the shadowy figures that run the securities industry tend to punish such actions: they reckon that such cash should be handed over to them in the form of fees for value diluting acquisitions.

So maybe, sometimes, repurchases of shares are based on factors other than managers’ personal self-interest. Certainly that’s what the managements will tell us, only the actual numbers imply something different. The actual numbers appear to suggest that managements are using stock repurchases to game the system and undermine shareholder value.

Management Greed

If we go back to 2007, a time that can now clearly be seen to have been a period of stockmarket overvaluation, US corporations spent nearly one trillion dollars on stock buybacks – roughly two thirds of net earnings that year. That’s an astonishing amount of money, most of it spent on overpriced stock.

In “Accounting Rules? Stock Buybacks and Stock Options: Additional Evidence” Paul Griffin and Ning Zhu have looked closely at the relationship between stock buybacks and CEO compensation and have found some interesting and suggestive correlations. Firstly they find that buybacks are a reliable indicator of share price movements. Unfortunately stock prices usually move down, not up, in the six months after a buyback.

Secondly the research finds that the decision to make a buyback and the amount of money deployed in the buyback is reliably correlated to the CEO’s stock option plan. All things being equal, the more stock options the CEO has the more likely the company is to engage in a really large buyback, regardless of the intrinsic valuation.

Not accounting for buybacks

There are a whole range of possible reasons for this behaviour including, of course, that the correlation is spurious. However, what seems to have happened is that the change in accounting rules on stock options around the turn of the century, forcing the recognition of earnings per share dilution caused by in-the-money options has led to an equal and opposite reaction – the use of company money to retire shares from the market. The buybacks, in essence, balance out the negative effect on earnings per share of stock option cost recognition.

Partly, the authors speculate, this is because of weak accounting mechanisms around buybacks which allow managements to avoid transparency on the issue. The resulting impact on the share price suggests that shareholders aren’t really fooled. Although this isn’t definitive it also suggests a reason why managements prefer stock buybacks over dividends – dividends dilute earnings per share, buybacks don’t.

Perverse Games, Again

All of which suggests – surprise, surprise – that managements in general and CEO’s in particular are gaming the system to their own advantage and against that of their investors. In general buyback companies tend to be smaller, in more leading edge industries and have significantly larger stakeholders on their boards. The lesson is that investors looking for long-term value should be extremely wary of companies with these characteristics because they may be diluting shareholders’ long-term gains in favour of their own short term benefit.

Of course, these are trends we’ve seen before. Developing perverse incentives to game the system is what most humans do given half a chance: it’s called self-interest, it was one of Adam Smith’s guiding principles and it’s both legal and perfectly predictable. However, rewarding such behaviour with our money is to play the wrong game. Stock options are nearly always a lousy way of aligning management and shareholder interests: investors should minimise their exposure and maximise their own self-interest wherever possible.


Related Articles: Perverse Incentives are Daylight Robbery, Correlation is not Causality (and is often Spurious), Gaming the System

Rise of the Machines

High Frequency Trading

Proponents of high frequency trading tell us that they’re doing us all a service by improving liquidity in markets, which supposedly benefits everyone. However, to implement their strategy they’re prepared to pay a fee to get microscopically early access to prices. So, if you take the liquidity argument seriously, this suggests that these altruistic traders are paying stockmarket operators to give the rest of us a free ride, out of the kindness of their hearts.

Presumably no one really believes this. However, the trouble is that the rise of the machines exposes the fragile markets of the world to yet another possible source of mass extinction. Time for the Terminator. Again.

Automated and Algorithmic

The concept behind high frequency trading is simple. Practitioners pay a fee to markets to get access to real-time data a tiny fraction ahead of everyone else and then hugely powerful computer systems driven by automated trading software search out short term pricing anomalies and seek to exploit them.

Hidden deep behind this is the idea that although stock prices theoretically follow a random walk – which essentially means that a stock’s price in future is not predictable from its price now (which would thus instantly invalidate a thousand trading strategies) – there is evidence of autocorrelation in markets which says that this isn’t quite true. As Campbell, Lo and MacKinley put it in The Econometrics of Financial Markets:

“The fine structure of securities markets and frictions in the trading process can generate predictability. Time-varying expected returns due to changing business conditions can generate predictability. A certain degree of predictability may be necessary to reward investors for bearing certain dynamic risks.”

It may be a wild shot in the dark but I’m guessing the authors think that there may be some predictability in market behaviour. The evidence they quote supports them.

Short-term trading techniques aim to exploit this asymmetry in markets. However, the ultra-fast reaction times of the latest market networks and the power of the supercomputers employed has changed the rules. These systems give the high frequency traders a tiny and fleeting advantage over other market participants. Tiny and fleeting, however, can be enough to make lots and lots of money if you do it often enough.

Asymmetric but Liquid

However, what’s got everyone suddenly hopping around is that it’s been spotted that the systems allow asymmetric, differential price discovery. So, for instance, they can rapidly submit small fill or cancel orders with escalating prices to discover the price lower frequency traders – i.e. the man, woman or extra-terrestrial in the street – is prepared to pay. This is a bit like entering a negotiation in which your opposite number can discover the maximum price you’re prepared to pay in return for a paying a fee to a third-party.

Although everyone’s getting excited about whether this is wrong the more important question is whether it matters. The proponents of the approach – primarily the people making money out it – argue that they’re performing a public benefit by driving up market liquidity. Some estimates suggest that half of all trades in New York are driven by the rise of the machines. Greater liquidity drives down the cost of fees so, “obviously”, this is good for everyone.

Of course, it isn’t: the idea that a bunch of financial engineers have anyone’s interest at heart but their own is so ludicrous that it makes a mockery of any media outlet that even advances the argument. Lower fees may result but the only people who benefit are the high frequency traders. For everyone else what’s gained in lower fees is lost in higher prices as they’re sampled by the bots testing our preparedness to pay a higher price.

An Unfair Advantage?

However, the problem doesn’t seem to be with differential access to pricing information per se – this happens already where active traders are prepared to pay a fee for real-time prices and market maker information while us more sedentary types are quite happy with delayed prices. You don’t find many traders suggesting that practise should be banned because some people are too poor to afford access or computers.

No, the problem is that in order to use this differential pricing information you need gazillions of MIPS of computing power, which is not available to mere mortals. Only the superstars of the global securities industry can play this game.

To which one has to ask – why is anyone surprised?

Who Cares?

Logically any private investor who’s disadvantaged by the high frequency bots is already shackled by their own faulty psychology. Taking a wide angled view the idea that any small time practitioner can exploit short-term pricing anomalies when up against the might and money of the global securities industries is a bit like asking someone to go powerboat racing in a pedalo. No matter how good they are they’re not going to win.

So playing the short-term trading game is, for the most part, simply delivering cash into the ever gaping maws of the investment industry’s whales. If it wasn’t self-evident before surely the rise of high-frequency trading clarifies that the securities industry has short-term trading weapons private traders can only goggle at? Complaining that it’s unfair is to miss the point that if you insist on taking on the US Navy in a rowing boat armed with a herring then getting the United Nations to ban the use of submarines isn’t going to make it an even fight. Oops, there goes another nuclear depth charge.

The securities industry will continue to extract cash from those investors foolish enough to believe they can beat it at its own short term game while simultaneously using its profits to pump out the message that short-term trading is profitable. And, it is – for them.

Fundamentally Patient

As far as most private investors are concerned high frequency trading should be irrelevant most of the time. The miniscule differences in prices that the high frequency trading bots are exploiting will make no difference to longer-term returns and the longer-term is the only perspective from which the private investor has any hope of consistently outperforming.

The general inability of the investment industry to think beyond the end of the next quarter means that the long-term investor focused on fundamentals rather than behavioural trading patterns at least has a chance on a playing field slanted in their direction. You can’t beat a bunch of supercomputers at their own game but not even a surfeit of supercharged silicon circuits can detect intrinsic value. In truth the value led investor should scarcely need an abacus as long as they’re in possession of a full set of digits.

Although Excel will do at a pinch.

Terminator’s Not Coming

There are wider problems with the rise of the machines. Firstly, the idea behind the joint stock company wasn’t this type of high speed flipping which divorces ownership and responsibility. Arguably these companies are too important to the world economy to allow them to be destabilised by this type of disenfranchised virtual ownership.

Secondly the use of computer trading mechanisms like this is fundamentally dangerous. These automated models are engaged in an escalating arms race as the boy wizards on either side seek to rapidly code algorithms to gain an advantage over their competitors. Yet these systems are, once again, picking up pennies from in front of the steamroller. It’s a matter of time before a program slips over on an unexpected environmental banana skin and gets squished.

The failure of one of these systems, either due to a set of unforeseen external circumstances or a software bug, will have unpredictable consequences. The results of such a happenstance is problematic, but history is not an encouraging guide. Human mediated systems handled at human speeds are prone to all sorts of unexpected failures. As the high frequency trading programs step out of the shadows we enter another world; and if these machines rise up against us there’ll be no leather clad saviour hiding behind designer shades from the future to save our sorry asses this time.


Related Articles: Quibbles With Quants, Econophysics, Consciousness and Cosmic Karma, It’s Not Different This Time

Investors, You’ve Been Framed

Lakoff's Political Frames

Suddenly politicians are all excited about a psychological trick that’s been known about for years. This is in no small part due to George Lakoff who’s popularised the idea of ‘framing’ in political circles. In the simple terms that politicians will understand, framing is about using the right loaded phrases and words to position yourself.

So, for instance, the American Army engaged in a ‘surge’ in Iraq: a short-term, rapid build up and assault is what comes to mind, rather than a long-term commitment. Or consider the renaming of the aggressive British Ministry of War to the protective Ministry of Defence. Or the various euphemisms for firing people: “sorry we have to let you go”. Such phrases create frames and these cause underlying behavioural biases to trigger in certain ways. As usual with psychological tricks the effect of this on individuals’ investing habits is largely bad.

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Peak Oil, The Revenge Of Planet Earth?

Depletion or Destruction?

A recent report from the UK’s Energy Research Council, a body not known for sounding panicky alarms, suggests that under all reasonable scenarios the rate of global oil production will peak by 2030. By their worst case estimates it’s already done so. The reality of a world of depleting oil resources is upon us: green activists would argue that it’s a race between depletion and destruction.

As this is a situation that will affect the vast majority of people alive today it’s something you might think would be at the top of policymakers’ agendas. However, in the dash to save the world from economic collapse this is about the last thing on their minds. So the question is probably whether the market can save ourselves from ourselves. Based on recent experience of oil trading it’ll probably pay not to be too hopeful.

Wanton Irrationality

Oil is no less subject to bizarre and wantonly irrational behaviour by traders than any other market. We certainly saw evidence enough of this in 2008 when oil prices spiked at near $150 a barrel. At this point all sorts of odd behaviour started to appear. There was a bubble in small oil companies with no assets other than a dubious claim on a scrubby bit of land in some far-flung, God-forsaken, hell hole. Well, that’s if they actually had any claims at all.

While all this was going on oil traders spotted that that the futures price of oil had soared, leading to a big gap between it and the actual real ‘spot’ price of a barrel (technically when the future price is greater than the spot price a commodity is said to be in ‘contango’, probably because ancient traders couldn’t spell). This situation led many traders to vigorously engage in arbitrage, selling futures and buying actual oil – which they then needed to store until they had to deliver on their futures contracts.

So they started hiring oil tankers to slowly steam around the world carrying the excess oil. Which led to the wonderfully paradoxical situation where the world was awash with the black stuff even as the price climbed to ever more ridiculous levels and everyone started moaning about the price of gas. And, of course, small investors piled into oil and oil stocks.

Fiction and Fact

Then Goldman Sachs suddenly moved their top-of-the-range peak oil price prediction up to $200 a barrel. That, of course, was the cue for a crash even more vertiginous than that of stocks, down nearly 80% at the worst point.

Underpinning all this amusing nonsense, however, are some brutally realistic facts. As the ERC report relates:

“Although there are around 70,000 oil fields in the world, approximately 25 fields account for one quarter of the global production of crude oil, 100 fields account for half of production and up to 500 fields account for two thirds of cumulative discoveries. Most of these ‘giant’ fields are relatively old, many are well past their peak of production, most of the rest will begin to decline within the next decade or so and few new giant fields are expected to be found.”

What had started as a upwards move based on some pretty sensible oil market fundamentals ended up as a behaviourally induced rout when the inflated expectations of emotionally compromised investors were burst by a nasty dose of economic reality. Situation normal, then.

The Impact of Oil Depletion

What’s worse, and makes some of the irrational moves in the market even more explicable, is that the data from these giant fields is often not publically available being both commercially and, in some cases, nationally, sensitive information. As we saw in Ambiguity Aversion uncertainty is a major factor in investor perceptions and in situations characterised by it it’s to be expected that you’ll see emotionally driven swings in prices, often quite sharp ones. In reality the facts about peak oil will emerge only slowly and in hindsight.

Normally we can’t know what impact such an event will have. The world is too complex to make multi-faceted predictions about stuff that lies far in the future. Mostly we don’t have a clue about what will happen next week. Without knowing future economic conditions we can’t even predict energy consumption requirements – the current downturn has reduced oil usage quite sharply, for instance – let alone oil production levels.

So we don’t know what impact new energy sources will have or whether attempts to reduce CO2 emissions will help. We don’t know how quickly oil fields will deplete or whether new giant ones will be found. We don’t know what effect the huge potential growth in China and India will have. We don’t know if the Middle East will go up in flames and Iran will close the oil gateway to the world, the strategically critical Straits of Hormuz. We don’t know whether governments will wake up and actually do something useful.

OK, maybe we can guess the answer to the last one.

Some Certainty in an Uncertain World?

However, we do know a few things with something approaching unusual certainty. We know that the probability is that the window of peak oil production is upon us. We know that investment in alternative energy resources is woefully lacking. We know that people will not easily be weaned off their energy dependency.

At some point there will have to be a sustained attempt by the developed world to develop new energy sources. An increase in nuclear usage is a virtual certainty. Improvements in wind, solar, agri-power and other sources will also come. Significant and sustained increases in energy prices of all kinds is virtually assured: the problem is that replacing oil completely will take a long time. The Hirsch Report commissioned by the US Department of Energy estimates that it’ll take at least 20 years of sustained investment before the peak to avoid serious energy dislocation. It may already be too late to achieve that.

Pascal’s Ultimate Wager
 
It’s impossible to discuss energy issues without addressing global warming. We know that it’s happening, we just don’t know what effect it will have. Applying Pascal’s Wager suggests that the worst-case downside of allowing it to continue unchecked – the death of most of humanity – is probably worse than the worst-case downside of stopping it – a significant reduction in global economic growth. Of course, Planet Earth would continue without us, no doubt vowing to never repeat that particular experiment.

The way forward in a world in which oil is hideously expensive is not clear-cut. One route leads to a vast increase in global coal consumption, a path that will do nothing to save the polar bear, the other to a more sustainable future but at the cost of much reduced economic growth. As that famed economist Woody Allen opined:

“Today we are at a crossroads. One road leads to hopelessness and despair; the other, to total extinction. Let us pray we choose wisely.”

Our past unwillingness to plan properly for the future means that energy is going to become a lot more expensive, at least in the medium term. Everyone should prepare themselves accordingly, we all need to choose which price we prefer to pay.


Related Articles: The Malthusian Prophesy, The Tragedy Of The Financial Commons, Pascal’s Wager – For Richer, For Poorer

Intelligence Can Seriously Damage Your Wealth

Cerebral Investors

In most walks of life intellectual superiority is generally viewed as something that gives the possessor an advantage over their fellow humans. Admittedly measuring intelligence is a pastime fraught with difficulty and hedged in contradiction but, even so, there are a few easy ways in which we can distinguish people who have better than average analytic abilities. Whether that’s the same as being clever is another matter, but it’ll have to do for the current considerations.

As investing itself is often viewed as a cerebral occupation, an area where the spoils fall to the smartest, we ought to expect to find a good correlation between intellect and returns. After all the calculation of alphas, betas, coupons, coefficients, efficient frontiers, adjusted earnings and the rest of the paraphernalia beloved of market gurus is pretty complex stuff. Of course this is a myth: simply being smart isn’t anywhere near sufficient to succeed in stocks.

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A Sideways Look At … Economic Models

Economic Models on the Psy-Fi Blog

Almost inevitably economic models keep on appearing on this blog, an annoying but inevitable occurrence. These models underpin so much of what happens in finance that it’s impossible to ignore them. In fact they’re now so important that the models themselves can change markets, although usually only because they’ve screwed everything up again.

All models are simplifications of the real-world – a model that described everything would have to be bigger than the universe, so until we can figure out how to start consuming other dimensions we’ll have to make do with approximations. Of course, when we do break out of this cosmos we’ll end up with a bunch of do-gooders complaining about the effects of dimensional change as vast chunks of the space-time continuum break off and strand the pan-dimensional equivalent of the polar bear.

Anyway, here’s a brief summary of the Psy-Fi Blog’s thoughts on economic models …

Newton’s Financial Crisis: The Limits of Quantification

It all started nearly three centuries ago when a bewigged philosopher-scholar named Issac Newton went and invented calculus in order to model planetary motion. Soon if you weren’t using maths to do your modelling other physicists were calling you a sissy. It wasn’t long before generating mathematical models became the gold standard for everyone and that’s where the trouble started. The next thing you know we have the Efficient Markets Hypothesis:

“The Efficient Market Hypothesis is one of the great blights of modern investment analysis. What it says is that markets price efficiently, all the time. So all known information is already in the price of stocks or bonds or whatever which means that unless you know something that’s not in the public domain you can’t, on average, profit by trading. The corollary of this is that you can develop mathematical models to describe – and predict – market movements.

Charlie Munger, the octogenarian billionaire Vice-Chair of Berkshire Hathaway has a name for the Efficient Market Hypothesis. He calls it “bonkers”.” >> Read More

Markowitz’s Portfolio Theory and the Efficient Frontier

In investment circles math was, for a very long time, something done by rocket scientists. In the wake of the Second World War the climb and climb of the stockmarket led many to think that there was something inevitable about the perpetual rise of stocks. Then the seventies hit, the Arabs decided that the oil in their countries was, well, theirs and the markets went into a dizzying tailspin.

Belatedly recognising the existence of risk, and casting about for some way of managing it, fund managers happened upon some twenty year old research which equated risk with volatility and meant that everything could be boiled down to a few simple numbers. The Efficient Market Hypothesis and models that go with it were born.

“What Markowitz did was put a number on risk to allow it to be managed. The first danger for investors is in not understanding the importance of Portfolio Theory for risk management of stockmarket investments. The second is in believing that it can explain everything. People don’t get programmed linearly – we come with randomness built in, not as an optional extra. Thank goodness.” >> Read More

Of course, no one understood the downside of what rapidly turned into a quest for spurious precision.

Alpha and Beta – Beware Gift Bearing Greeks

Markowitz’s ideas led eventually to something called the Capital Asset Pricing Model (CAPM). CAPM assumes that returns from a market lie on a Bell Curve or, in the jargon, are distributed normally. Sometimes you get very bad returns, sometimes you get very good returns but mainly you get something in the middle. Only this turns out to be dead wrong.

“The markets can behave normally for long periods of time but when they go wrong it can be spectacular. Long Term Capital Management (LTCM) a hedge fund run by Nobel laureates found this out to their cost in 1998 when their normally distributed model collapsed when they were unable to sell assets at any price due to the collapse in the Russian bond market. Only concerted government intervention prevented a massive financial crisis.” >> Read More

The search for spurious mathematical precision was to lead to all sorts of problems.

Holes in Black Scholes

The LTCM Noble Laureates had made the basic assumption that the world they knew was the only world that there was to know and constructed their models accordingly. Unfortunately a human lifetime isn’t time enough to get to know even a fraction of the possibilities. What’s odd, not to say worrying, is that the inefficient Black-Scholes option pricing model that underpinned LTCM (which itself depends on the distribution of returns on a Bell Curve, aka the Gaussian distribution) is still in use today.

“Peer under the covers of Black-Scholes and you find our old friend, the Gaussian distribution, assuming that extreme events are impossible instead of just rather unlikely. The unlikely happens all the time in markets, usually because of human behavioural biases which kick in at extreme moments and lead to sustained overshoots in valuations and liquidity.” >> Read More

Of course, any hope that the lessons of the past would be learned by the financiers of the future was forlorn.

Risky Bankers Need Swiss Cheese Not VaR

Underpinning many of the risk models being used by financial institutions is something called Value at Risk (VaR) which attempts to measure the likelihood of an unlikely event under everyday conditions. Unfortunately, like many models, it’s open to abuse if the people overseeing it don’t know what they’re doing or are too distracted by large bonuses to bother. Guess what?

“To summarise a vast range of problems in simple terms, the people running the banks, the credit rating agencies and the regulatory bodies didn’t have a clue about the limitations of the risk management models they were all using. They were all looking at the same data and using the same models. And all drawing the same conclusions. Which were wrong. >> Read More

Which eventually led to the almost inevitable problems the world started reluctantly facing up to in late 2007.

Quibbles with Quants

The rise of all of these quantitative models, based on the spurious precision accompanying analogies with Isaac Newton’s models of gravitation, have resulted in continual market failures culminating in the crash of 2007-2008, which was by far the most spectacular implosion of math based financial models yet.

“The sheer nuttiness of the credit rating agencies changing their risk models purely because a quantitative model existed that indicated that the risk of these securities collapsing like dominoes in the event of isolated defaults was remote is still hard to believe. It’s not that the models didn’t indicate exactly that. … You’ve got to ask – did none of the overpaid executives running the world’s financial corporations and regulators actually stop to wonder whether someone might have, just possibly, failed to predict everything that might happen in the real world? Did none of them look at the collapse of LTCM and wonder?” >> Read More

The Death of Homo economicus

Dig hard enough into these models and you’ll uncover the idea of the perfectly rational human being, weighing up decisions in the light of perfect information. Yet the brain is, at best, an imperfect rationalising machine making all sorts of shortcuts in an increasingly desperate attempt to make sense of our information saturated world. In 1979 Kahneman and Tversky came up with a different model, behavioural finance, based on human psychology which suggest that …

“…investors – were more risk adverse when it came to protecting a profit than they were in trying to recover a loss.

So, in effect, if something went wrong with a stock they were holding the theory stated that they would be more likely to sell it if they were in profit than if they were making a loss. This is, indeed, illogical since it’s the same company with the same prospects. If investors were truly rational they would decide whether to sell or not based on the current information – stock history is irrelevant to whether a stock is currently a good investment or not. Yet the evidence suggests that this decision is, in fact, heavily biased by their personal history and, therefore, that the decision is not really a rational one.” >> Read More

Exit homo economicus, leaving a mathematical vacuum just dying to be filled.

The Special Theory of Behavioural Economics

The death of Homo economicus is required by behavioural finance, which looks at how intelligent human beings behave irrationally for the most rational of reasons. Increasingly it looks like the Efficient Markets Hypothesis is just what happens when we don’t all have some particular bee in our collective bonnets.

“A hypothesis, then, is that behavioural biases effect investors all of the time but while there’s a reasonable balance between different types of investors in the market any deviation in valuation is corrected, leading to a market that exhibits the hallmarks of a standard efficient model. However, this is only correct at the gross level – look under the covers and you’ll find a whole bunch of behavioural biases twitching away but doing so fairly randomly, cancelling each other out.” >> Read More

To Infinity and Beyond

If rational man is dead and the rational models they go with him are similarly extinct you’d hope that these adventures in stupidity are over. Unfortunately the quest for spurious precision through mathematical models that can be programmed to make institutions easy money isn’t likely to end any time soon. Whether any of these models can successfully integrate human behaviour is questionable but, on the other hand, perhaps we should hope that they don’t.

At least we can be reasonably sure that people will continue to do exactly what these models expect until they don’t. That’s the thing about people, we’re unpredictable. Which, fortunately, is still about the only predictable thing about us.

Anchoring, The Mother of Behavioral Biases

Behavioural Biases (5): Anchoring

Just as an anchored ship rarely strays too far away from its tethering point a human being prefers to stick close to the references with which they feel most comfortable. Anchoring is an easy-to-demonstrate, hard-to-eradicate behavioural bias that has all sorts of nasty implications for investors, many of them not obvious. In fact, along with availability, it has the claim to be the mother of all biases.

The fundamental investment problem lies in the difficulty in deciding what something is intrinsically worth. A skilled negotiator will start from an extreme position, such as a very high price, in order to frame the subsequent discussions. Anywhere and anytime someone presents us with a number in order to start negotiations we’re being anchored. So if it really matters then you need to start from your own number or walk away.

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What’s the Shape of Your Recession?

Clueless Commentators

Over the past few years we’ve had endless economic experts opining on the nature of the recession. From initial hopes of a bouncy V shaped recovery we moved onto a sluggish U and then a very droopy looking L before a dose of government pump-primed financial Viagra re-erected the idea of the V. More pessimistic predictors – mainly those who originally plumped for a U or an L – are now hopefully suggesting that we’ll get a double-dip W or a triple-dip VW in an attempt to save their remaining credibility.

Of course, the reality is that none of them have the faintest clue because none them possibly can have the faintest clue. We are, as always, in the uncharted waters of the future. The only letter that needs apply is the X that marks the spot where we bury the commentators and their useless predictions.

Blithe Ignorance

As we’ve sailed on through the treacherous shoals of economic uncertainty people have naturally looked to the world’s experts for advice. Occasional suggestions by central bankers, who actually have the real data to analyse, that they don’t have a clue what’s going to happen have resulted in shudders across world markets. Meanwhile commentators have happily carried on making essentially random predictions based on their thirty years or so experience of largely benign economic times. It’s like watching a weather forecaster from Hawaii trying to make predictions for the Mid-West: amusing, but not terribly helpful.

In fact, as economies have uncertainly recovered we’ve seen the standard reactions by experts who’ve been caught out (see You Can’t Trust The Experts With Your Investments). Many have simply ignored the fact that they were wrong and have blithely continued to make further predictions; presumably on the grounds that yesterday’s media makes tomorrow’s lining for kitty litter trays. Others have opted for the standard “I was right, but not yet” or “I was wrong, but for the right reason” responses as though getting your timing wrong about the world economy and causing people to flee into overpriced government bonds just as the biggest stockmarket rally in history kicked off is a normal sized mistake.

The highly respected John Authers of the Financial Times is one of the few who’s come out and admitted he got it wrong (which is one of the reasons he’s respected). However, the one point he should have made, but didn’t, in “OK I called the rally wrong” is that picking the trends that were important is easy with hindsight but was impossible to do with certainty at the time.

The Two Rules of Ignorance

Still, a few rare experts called it right, at least temporarily, and their opinions are increasingly and eagerly sought. The problem is that simply being right last time is no proof that they can get it right next time. In investment, of course, next time is the only time that matters – hindsight is a perfectly useless investment tool.

Unfortunately we’re at least partially programmed to look for advice from experts. In an increasingly complex world we know, as a proportion of total knowledge, less and less. We’re four hundred years past the time when one person could hope to know everything yet many of the decisions we’re called upon to make are horribly complicated and not having a guide to help us is impossible much of the time.

There are, roughly, two loose rules humans follow when called upon to make decisions that lie outside of our area of expertise. One is to follow the crowd, the other is to follow the expert. Both are decent shortcuts much of the time, both are highly dangerous in investment.

Herding

Following the crowd, although much derided, is a perfectly good strategy in lots of circumstances. Doing what everyone else is doing in an unfamiliar setting is as good an approach as any. If everyone else is eating the dodgy looking purple mush then it’s a safe bet it’s not poisonous – although there’s no guarantee it’s not disgusting (trust me, it was really disgusting). Herd following has a long and honourable history, and is certainly evolutionarily adaptive – children habitually copy their parents and other adults in order to learn more advanced behaviours. You know, stuff like getting drunk, betting on lame horses, buying overpriced property and reading magazine articles on talentless micro-celebrities who’ve the star quality of a dead skunk.

Of course, in individual investing, herding is often the wrong thing to do assuming that we’re trying to maximise our wealth. Although, it should be noted, the momentum effect – where shares that have gained continue to do so and losers continue to fail – is extremely persistent. The problem with this is that shares do, eventually, tend to mean revert and that usually catches the crowd unawares.

Ask The Expert

The alternative, to ask the expert, is also a method with a decent pedigree. In science based areas where there’s a dispute it’s a reasonable rule of thumb to go with the side that has the most experts, although not everyone completely agrees as David Coady sets out in When Experts Disagree. For most of us this has the most direct impact in medical matters. So, for instance, in the recent debates over whether the MMR jab could cause autism the vast weight of the establishment came down in favour of children having the inoculation. The dangers of not having it were real, the dangers of taking it uncertain and the risks, as usual, were exaggerated by the headline obsessed media.

Unfortunately experts aren’t always right. The advice of the child-rearing expert Dr. Spock to lay babies on their stomachs is now the exact obvious of the expert opinion in regards to cot-death. As Ben Goldacre has repeatedly written about on his Bad Science blog, pharmaceutical funded research consistently shows a bias in favour of positive results that isn’t seen in independently funded studies. This isn’t evidence of deliberate bias by the researchers, however, since we’ve seen before how unconscious psychological drivers can lead to this type of reporting.

Investment Advice

In non-scientific areas of research, like investment, the problem is much harder. The issue is that we’re not dealing with matters of fact but with matters of opinion. Mostly there is simply no consensus to base a decision on and we tend to gravitate to the expert who’s been most recently right. Unfortunately, if expert opinion is truly random then the most recently correct experts are probably those least likely to be right in future. But in truth, we don’t know.

So in financial matters our two most favoured short-cuts in areas of specialist expertise are almost bound to leave us in the lurch. Of course, mostly we follow these routes so automatically that we’ll go ahead and use them anyway, like a driver following a sat-nav over a cliff edge. The alternative is to try and acquire sufficient knowledge to do the job ourselves and here we tend to fall victim to a different bias – the idea that because it’s easy to do something it’s easy to do it well.

Simply being able to log on to a sharedealing site, purchase a few shares and see them roar is no evidence at all of investment expertise. In fact, there’s a good case for arguing that the easier it is to get access to a means of making money the harder it actually is to do so. Consider blogging, an activity engaged in by everyone from five year old toy collectors to octogenarian needle workers. Anyone can do it, which means making money from it is virtually impossible for new entrants: that’s the nature of basic economics.

Good Enough Expertise

As so often the best advice in this area comes from Charlie Munger who observes that in order to make difficult technical decisions you need to employ an expert and then gain sufficient knowledge personally to at least cross-check that they know what they’re doing. In investment that roughly equates to them not chasing every trend, not trusting research done by others and having a clear understanding of the fundamentals of valuation techniques and competitive advantage.

For the most part, though, you don’t want an expert who spends their time opining on the shape of nebulous concepts like recessions. Better find one that actually spends some time thinking.


Related Articles: Technical Analysis, Killed By Popularity, Ambiguity Aversion: Investing Under Conditions of Uncertainty, You Can’t Trust The Experts With Your Investments

Pricing Anomalies: Now You See Me, Now You Don’t

Imaginary Beasties

Down the years researchers have identified a whole host of pricing anomalies that offer strategies to outperform markets. Unfortunately as soon as anyone starts to exploit them these little beasts disappear like a bunny in a magician’s hat, leading everyone to wonder whether they ever existed at all.

The use of backtesting to identify such models which are then presented to the world as methods for getting rich – or at least ways of avoiding getting poor – shows, quite clearly, that the anomalies did exist at some point. So it appears we have the financial equivalent of the conjuror’s trick: now you see me, now you don’t.

Bad Models or …

There are two reasonable explanations of what might be going on. The first, roughly, is that the pricing anomaly really never existed in the first place and was the figment of fevered financial researchers’ imaginations. The second, even more roughly, is that as soon as the effect is identified then the market moves to eliminate the inefficiency: which is, after all, what you’d expect of an even vaguely efficient market.

The possibility that some of these effects never existed at all is a serious one. To identify the anomaly in the first place you have to have something to baseline it against. Given that all of the models of markets we’ve seen so far are seriously deficient at the extremes (see The Death of homo economicus, Holes in Black Scholes, etc, etc) there’s every reason to wonder if these apparent pricing inefficiencies are simply errors resulting from the modelling. After all, most market models are built around assumptions of efficiency and even if these are only roughly right the existence of clear inefficiencies would be odd.

Of course, given that all anomalies are identified through backtesting the possibility is open that the effect was simply a statistical blip. Take other data sets from other eras or other markets or an alternative universe and it may disappear. This is almost certainly what’s happening some of the time – but not all of it.

Loose Market Efficiency?

Still, if the pricing anomaly exists but hasn’t been recognised then there’s no especial reason for the markets to arbitrage it away. The fact that the effects disappear after they become widely known would suggest that markets are loosely efficient – they don’t necessarily act of their own accord to remove inconsistencies but will, if pushed and prodded towards the problem, do the right thing like a child eating its vegetables under duress and the promise of a highly calorific dessert, a new bike and the latest computer console. Slowly and painfully.

If you follow this logic through, even roughly, it would suggest that any pricing anomaly which becomes well known will disappear – even ones that are clearly based on human behavioural weaknesses. After all, in an age where mass computing power is available to the financial institutions that dominate our markets and Harry Potter lookalikes with whizzy computer models can swiftly magic up a program to exploit any identifiable discrepancy we should be moving towards greater market efficiency.

Instead of which, of course, we’re not. Which is good because otherwise I’d have nothing to write about.

And the Losers are …

As G. William Schwert points out, amongst the effects which were once bang-on winners but are now vanishingly irrelevant are the size effect, the value effect, the weekend effect and the dividend yield effect. The latter’s particularly interesting since an investment strategy based on predicting stock returns from historical dividend yield data was pretty successful up until the 1990’s when it failed spectacularly. Historically robust models can do you extreme damage if you trust in them too much: can anyone remember when bonds had never yielded more than equities? Nah, you’re all too young.

The value effect, where companies with low P/E ratios compared to the market earn excess returns, was identified back in the early 1980’s. Similar ‘value’ effects accruing to companies with high dividend yields or with assets in excess of their market capitalisations were also identified. However, when French and Fama modified the Capital Asset Pricing Model (CAPM) to take account of risk associated with company size and discounts to net asset value they discovered that the anomaly vanished.

Brilliantly the French and Fama three factor model rests not on the exploitation of reliable underlying market inefficiencies but on the fact that most of the market participants insist on using models that are demonstrably wrong. Here lies a delicious irony – it’s the activities of the boy wizards and their efficient market models that create the inefficiencies that allow others to make excess returns. They’re probably too busy fiddling with their broomsticks to take notice.

Heroic Smaller Investors

It really isn’t very hard to see why anomalies disappear once people start looking at them closely. What’s more interesting is why some anomalies don’t go all shy and retiring. The momentum effect, where stocks that have done well continue to do so and stocks that are lousy dogs keep on barking appears to be robust over all timescales and isn’t explicable by any modification of the current models. It’s also a possible explanation for the heroic underperformance of behaviourally challenged small investors who are apt to sell winners, which keep on winning, and keep losers, which keep on losing, in an attempt to continue to fund the securities industries’ enormous costs.

This underperformance is itself an anomaly, although one it’s difficult to exploit. Outside of the fat tails of market manic-depression one would generally expect even private investors to at least achieve market average returns. After all, efficient markets work both ways – it may be difficult to outperform but it should equally be hard to underperform. For their truly legendary efforts to disprove the Efficient Market Hypothesis smaller investors should be applauded, even if we simultaneously have serious doubts about their sanity.

An Exploitable Anomaly

It’s not just private investors that demonstrate such market beating, in a negative sense, abilities. Fund managers should, all things being equal, underperform the market to the extent of their fees. By and large this is true, low cost index funds included, but there are a few outstanding active managers who demonstrate the “cold hands effect” and produce underperformance of a magnitude that simply isn’t explicable by chance. As Hendricks, Patel and Zeckhauser put it:

“The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon. Portfolios of recent poor performers do significantly worse than standard benchmarks; those of recent top performers do better, though not significantly so.”

So there you have it, finally: a truly exploitable anomaly. Find the very worst performing fund managers and do the exact opposite. Otherwise work hard on your real job, invest regularly in index trackers across a number of asset classes and expect to make no more than 8% per annum on a compounded basis. If you do the sums and don’t like the outcome then work harder and invest more, don’t count on higher investment returns – especially if your alternative is to bet on a backtested anomaly. After all, you never know when the darned thing will disappear in a puff of smoke.


Related Articles: Investing With A Time Machine, The Case Of The Delusional Investor, Real Fortune Telling: Dividend Forecast Indexing

Your Financial Horoscope

Using the latest in IP address geo-detection and profiling technology we’re delighted to bring you your personalized horoscope:

You have a great need for other people to like and admire you. You have a tendency to be critical of yourself. You have a great deal of unused capacity which you have not turned to your advantage. While you have some personality weaknesses you are generally able to compensate for them. Your sexual adjustment has presented problems for you. Disciplined and self-controlled on the outside, you tend to be worrisome and insecure on the inside. At times you have serious doubts as to whether you have made the right decision or done the right thing. You prefer a certain amount of change and variety and become dissatisfied when hemmed in by restrictions and limitations. You pride yourself as an independent thinker and do not accept others’ statements without satisfactory proof. You have found it unwise to be too frank in revealing yourself to others. At times you are extroverted, affable, sociable, while at other times you are introverted, wary, and reserved. Some of your aspirations tend to be pretty unrealistic. Security is one of your major goals in life.

Trick or treat?

Cargo Cults

In the Second World War many remote Pacific islands found themselves occupied by warring forces. This often led to an unexpected windfall for the primitive islanders as the troops were supplied from the air with unimaginable luxuries like corned beef, custard powder and anti-aircraft guns. When the war ended and the troops went home the planes stopped coming so, naturally, the islanders hatched a cunning plan to make them come back again.

They created the rudiments of the apparatus that the ground crew had used – paddles to welcome the aircraft, fake headsets for the radio operator, fake landing lights – and engaged in the same strange ritual ceremonies, behaviour generally known as a cargo cult. Yet no matter how they adjusted the ceremony they couldn’t get it quite right and the planes never came back. It would be crass simplicity to suggest that the same kind of magical thinking pervades the world of investment. Only it does, of course.

Paranormal Beliefs

The curiously enduring nature of belief in the paranormal is one of the mysteries of the modern age. Less than 50% of the world’s population believes in evolution despite copious evidence in its favour, much of it propping up the nearest bar, yet a majority happily accept the probable existence of invisible, incorporeal and undetectable entities of which science can find not the slightest trace. This isn’t explicable under the normal definition of “rational”.

Many practitioners of magic argue that this widespread belief in things that go bump in the night is de-facto evidence that there must be something “out there”. Only almost certainly there isn’t, but there’s definitely something going on inside our heads: we’re infinitely suggestable. This factor, combined with our desire to seek forms of control in situations of extreme uncertainty is a powerful driver of behaviours that we’re apt to label as “irrational” when, in fact, they’re nothing of the sort.

When the Irrational Isn’t

The smoking gun that leads to the redefinition of “rational thinking” was discovered in the Trobriand Islands. The anthropologist Bronislaw Malinowski noticed that the islanders engaged in elaborate rituals when they went deep sea fishing but not when they were fishing inshore. He surmised that the open seas superstitions were an attempt to protect themselves from danger in a fundamentally uncertain environment.

This tendency to attempt to exert some form of control, no matter how illusory, in the face of great uncertainty, seems to be part of the human condition. Various studies, including this one on the superstitious behaviour of baseball players, back the theory up. The evidence is that people attempt, always, to put themselves in a position where they feel they have control of the situation, regardless of the reality: the so-called “illusion of control”.

Magical Investment Thinking

Now, boys and girls, can we think of another situation where people are essentially at the mercy of random and unpredictable events and spend a lot of time developing ritual behaviours to make them feel as though they have control of the unfolding events? Admittedly, the stockmarket is an extreme example of the genre – a global manifestation of a belief in magical forces leading to the mass delusion that we can predict the movements of individual stocks, markets and economies.

While primitive tribesmen have mystical seers, priests and soothsayers we have investment analysts; while they have chicken entrails, hallucinogenic drugs and animal sacrifice we have multi-year earnings forecasts, better hallucinogenic drugs and occasional executive bloodlettings. Simply clothing the magical rituals in a smart suit and a well formatted report doesn’t make the outcome any more predictable and the rituals any less pointless, but it does make us feel better when things go pear shaped and we go looking for reassurance.

Logical or Astrological?

In fact if this theory is correct we should see an increase in such magical behaviour during conditions of extreme market movements; a greater reliance on divining the future using essentially random techniques, and indeed we do. In times of uncertainty many people abandon any pretence of higher cognitive functioning and head off in search of their nearest soothsayer.

For instance, if you type “investment astrology” into Google you’ll get over 2 million hits. The survival of astrology into the modern age is itself remarkable but huge swathes of the world’s population still conduct their lives according to the prophetic divinings of invisible, undetectable and unmeasurable forces that enmesh us at birth and mark us for life. Apparently.

Yet, as has been repeatedly demonstrated, the evidence for astrology actually working is decidedly thin away from areas of human suggestability. So, for instance, those people who believe in astrology tend to have personalities that conform to their astrological signs while people who don’t, don’t. Belief is a powerful weapon in human systems but it sadly doesn’t mean that magical thinking can actually have an effect on the physical world around us.

Supernatural Stockmarkets

Only, of course, the stockmarket isn’t the real world. It’s an artefact of human construction and is therefore open to manipulation through all of the kinds of things that we let affect us. In theory the performance of stocks on the market is determined by fundamental factors like earnings, competitive advantage and marketing. In the long-run this is generally true, but in the short-term magical modes of thinking can easily overwhelm more fundamental factors.

Still, you’d assume that if astrology, charting and other magical modes of prediction were completely useless then their repeated failure would eventually persuade people to give them up in favour of something more rational like chain-saw juggling or duck weaving. However, it’s far from being that simple because we’re all subject to being fooled by a behavioural trick called the Barnum Effect.

Roll Up, Roll Up, Get Things Wrong

This was first demonstrated in 1949 by Bertram Forer who constructed the fake horoscope at the head of this article using the most general astrological statements he could find. He presented this to his students, explaining that it had been customised for each of them when, in fact, he gave everyone the same reading. When he asked them if it accurately represented them they virtually all agreed that it did. This trait – to see insightful information in the most general rubbish – is the stock in trade of all magicians, astrologers and other sayers of soothes:

“It was pointed out to them that the experiment had been performed as an object lesson to demonstrate the tendency to be overly impressed by vague statements and to endow the diagnostician with an unwarrantedly high degree of insight. Similarities between the demonstration and the activities of charlatans were pointed out”.

Everyone is prone to the Barnum Effect and it works because we think the same way. We read into things whatever we want to: again, it’s not that there’s anything “out there”, it’s all inside our heads.

Stocks that go Bump in the Night

The idea that most investment is driven by magical thinking underpinned by psychological tricks like the Barnum Effect is disquieting, but once you start looking for examples it becomes all too easy to find them. Astrology is simply the most obvious outward sign of this, but sneering at astrological investment techniques while continuing to faithfully follow more orthodox but equally magical processes ignores that this is the way most of us deal with uncertainty.

For children Halloween comes once a year but many investors spend their entire lives trick or treating. Sadly most treats are just tricks and most tricks are just illusions that we fool ourselves into believing. Trouble is we can only see this with hindsight – and that’s if we ever figure it out at all.


Related articles: Science, Stocks and Superstition, O Investor, Why Art Thou Rational?, Don’t Lose Money In The Stupid Corner