Monte Carlo Simulation or Nuclear Bust

Escape from Berlin

It's 13th July 1938 and an elderly lady of Jewish extraction is boarding a train in Berlin for the Dutch border, barely escaping the grasp of the Nazi authorities. In one of the great switchback points in history the onrushing locomotive of destiny has found itself diverted down a path that will lead, circuitously, to the end of the Second World War, the triumph of the great liberal democracies and the rise of quantitative financial modelling.

Her name is Lise Meitner and now, as we leave her travelling her lonely path to exile in Sweden, she has just 10 marks in her purse. And the key to the atomic bomb in her head.

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Cardano’s Gambit

Gamblers ‘Nonymous

Investing is, up to a point, gambling. Most of us don’t think of it in that way but if we conceive of the universe of stocks as a gas of randomly moving particles buffeted this way and that by forces largely beyond their – and certainly beyond our – control then there’s no other conclusion that can be drawn.

However, we don’t really believe this. What we generally believe is that although randomness is pervasive in stocks there’s a pattern that lies beneath the surface which we, in spite all evidence to the contrary, can pick out. For the idea that there are repeatable patterns hidden within apparently random games of chance we can thank one of our more unlikely heroes. Meet Girolamo Cardano, medieval physician, professional gambler and mathematician extraordinaire.

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The Unintelligent Investor

Be Smart, Play Dumb

Most of the people who provide advice on stocks are either wrong or simply practising their sharpshooting, painting targets around their bullet holes. This means that the few people who actually know what they’re talking about and have proven track records form the small subset of humanity from which we might actually hope to learn a few lessons.

Unfortunately even the real gurus tend to have a less than one hundred percent record when it comes to not getting things catastrophically wrong. For all that they profess to follow the strictures of Ben Graham’s classical tome, The Intelligent Investor, all too often it seems that random happenstance of everyday life defeats the planned smartness of the human being. Operating as though we’re unintelligent is the best bet for most of us, because that’s exactly what we are.

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Time for Shiva and Schumpeter

Destroy Who You'd Make Good

There comes a time in every desperate recapitalisation of the creaking financial system when governments need to bite the bullet and then use it to put broken-down institutions out of their misery. Capitalism is, at its heart, a recapitulation of the basic Hindu principle of regeneration. Until there’s destruction there can be no creation.

In their desperation to shore up the world’s banks politicians can lose sight of this basic principle. It’s one thing to protect deposit holders – although allowing them to make reckless gambles without the promise of commensurate pain opens up a world of moral hazard – it’s entirely another to offer shareholders and managers a free hand with bottomless pits of taxpayer’s cash. Vishnu the Preserver’s had his day, it’s time to let Shiva the Destroyer out of his cage.

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The Language of Lucre

Talk the Talk

Once we get past blood-lust, misogyny and an insatiable desire for saturated fat presented in peculiar forms, language is probably the defining feature of humanity. Thus it’s unsurprising that some psychologists think that human behavior is defined by language, rather than through some cognitive super-controller that oversees our every action.

Discursive psychology, the study of how language impacts human behaviour, would expect to see investors swayed by use of language in a way that more rationalist theories would not. Language deployed by the financial media might, for instance, be employed to promote buying or selling of stocks regardless of their fundamental attractions or otherwise. Which, of course, is a stupid idea and therefore, inevitably, looks like it’s probably correct.

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Warren Buffett Bias

Danger, Buffett Speaks

It’s a racing certainty that more people have lost money following the wisdom of the Sage of Omaha than following tips from any number of other so-called gurus. Of course, it’s perfectly correct that virtually every pearl of wisdom dripping from the lips of the Chairman of Berkshire Hathaway is worth a thousand utterances from the plethora of mass market media mavens masquerading as psychic predictors of the unforeseeable. Unfortunately there are two sides to every equation and Buffett, hard though he tries, can only be on one of them.

The simplicity of Buffett’s approach and his folksie wisdom belie a tough-minded and intensely focused individual whose career has been marked by a single minded determination to make money. Most people don’t see this, though, what they see are the incredible gains that can be made by actively trading and draw the obvious, but mad, conclusion that what’s good enough for the one person capable of defying the logic of markets is good enough for them. Following Warren Buffett without Warren Buffett’s temperament is a one-way ticket to the poorhouse.

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Maxwell’s Demon Investor

Self-Organising Wardrobes

In the long-term we’ll all be dead because, in the long-term, there is no escape from the iron hand of thermodynamics which tells us that every system moves from a state of order to one of disorder. It’s a bit like your wardrobe spontaneously re-organising itself. Only when it’s finished you can’t actually find anything in it any more. Neat but bloody useless.

The measurement of order in a system is known as entropy and the idea that entropy always increases is bound up with the idea that energy ultimately moves from a useful and usable state to one in which it’s unusable and useless. And this is as true of stockmarkets as any other system – not even the perfect demon can outperform the markets other than by luck unless they can also escape the laws of physics. Entropy rules – OK?

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Diworsification is Good for You

Mythic Investments

We all know that over-diversifying our stock portfolios is bad for our wealth. Even if our main aim is simply to avoid the problems of correlated stocks all falling together it’s well known that you can get most of the benefits of diversification from a portfolio of no more than fifteen companies. Anything else isn’t diversification it’s diworsification: it adds no benefit and costs us more.

Only, like so many well-known truths about stocks, this is a myth. Owning as few as fifteen stocks opens you up to all of the terrible things that happen to investors that take on too much risk. In the worst case everyone loses money and you get a socialist government. How bad is that?

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Game On: Basel III

Bonfire of the Principles

The next set of banking regulations, aka Basel III, has arrived, albeit it'll be implemented one micro-step at a time. It has, of course, been accompanied by horse-trading of the kind that can only be done behind closed doors by an unelected and unaccountable body. After all, it’s not as though their actions will ever affect the rest of us, is it?

Regardless of what this shadowy group has decided the actual behaviour of the world’s financial community will continue to be cautious while the pain engendered by its latest fiasco remains large in the minds of its officers. Yet these memories will fade and animal spirits will once again take over, when Basel III will become, like its predecessors, an opportunity to be gamed, not a constraint on unethical behaviour. In the end we need less rules, more principles and better regulators.

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