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Showing posts with label investing history. Show all posts
Showing posts with label investing history. Show all posts

Sunday, 18 October 2009

Property Rights and Wrongs

It Begins: The Magna Carta

In 1215, at Runneymede in England, King John set his seal upon the document known as Magna Carta and thus kicked off nearly a thousand years of property madness. The charter was the result of the King’s ruthless trampling over the rights of existing nobles and, extracted from him at the point of a sword, gave all freemen of England certain, inalienable rights.

One of these was the right not to be unlawfully deprived of their property and, such is the way of these things, this was to lead to the Anglo-Saxon obsession with housing which has been at the heart of so many recent financial debacles. It may be that “an Englishman’s home is his castle” but mistaking a heavily mortgaged property for a safe financial haven isn’t the cleverest bet you’ll ever make. Although it may still be better than investing in the stockmarket for most people.

Property Rights

At the heart of the Magna Carta were a number of provisions that echo down the ages:
“No free man shall be seized or imprisoned, or stripped of his rights or possessions, or outlawed or exiled, or deprived of his standing in any other way, nor will we proceed with force against him, or send others to do so, except by the lawful judgement of his equals or by the law of the land.”
The document is, to be fair, rather a rambling read and at points gets oddly excited about making the King give back all the stuff he’d stolen from Wales including “the son of Llywelyn”. Quite why King John had such a liking for the Welsh isn’t recorded, but they clearly weren’t happy with the attention. According to the charter he’d also acquired the sisters of the King of Scotland on his travels, so he seems to have been an inveterate Celtic kleptomaniac.

Although the charter enshrined a lot of rights, many of which are traceable into important future constitutional documents like the American Declaration of Independence, the English more or less observed it in the breech for a few hundred years. Kings may have nominally been as one with everyone else before God but in practice they had the biggest armies, the most secure dungeons and an awful lot of nasty looking torture implements.

Edward Coke and the Common-Law

By the sixteenth century, however, the jurist Edward Coke was using the Magna Carta as justification for the development of some of the most important aspects of the English common law – the haphazard set of case studies that determine precedent and hence guide judges and jurors. Coke in many ways wrote the book (actually four books) of common-law but is perhaps best known for refusing to kneel in the presence of the King, arguing that no man was above the law. Charles I later slung him in the Tower of London, which suggests that the authority of the law was somewhat more limited than Coke would have liked.

Anyway, between them Coke, the Magna Carta and common-law established many of the rights we hold dear today including the protection of real property rights. These are a critical issue for the development of democracy and capitalism – the Soviet Union thoughtfully provided us with a seventy year study of what happens when you deprive people of such rights: bad dentistry, rotten cars and a secret police state George Orwell would have been proud of. Despite all the other trappings of modernity the system buckled: when no one owns anything what incentive does anyone have to improve themselves?

Shakespeare’s Property Ode

In England, however, this had some odd consequences. For reasons that might escape us in these more modern times were it not for the fact that they haven’t changed very much, mostly the English didn’t trust their government very much. In fact when annoyed they regularly rioted and strung up a few representatives to keep the others in their place. Way ahead of their time, they didn’t put much trust in bankers or ye olde financial advisors either. It’s amazing how little the world changes over the centuries.

On the other hand, the rights that the common-law protected provided everyone with a strong incentive to own a property. Unlike gold or coins a house was pretty darned difficult to steal during the night (although they did have a nasty tendency to burn down from time to time) and, to boot, could be relied upon for an income. William Shakespeare, for instance, invested his earnings extensively in property – including the then enormous sum of £320 for land in Stratford-upon-Avon in 1602 and £140 for the gatehouse of an old priory in London in 1613.

Empire and Housing

The English fascination with property gained a wider foothold as the spread of Empire took with it the English language and the common-law. Looking around the world at where home ownership is most popular and property booms most frequent you’ll find a pretty decent overlap with British historical involvements. Japan, of course, is the ultimate exception, but that’s what you get when an outsized population meets an undersized land mass. And, of course, the post-war Japanese constitution was modelled on the British system.

The Anglo-Saxon obsession with property means that many private investors prefer housing to stocks. People feel that they understand how to value a house whereas the movements of the stockmarket are unfathomable. Additionally there’s the added ‘benefit’ that a house is a hugely tangible thing, unlike shares. The visibility and speed with which share prices can move is frightening to the uninitiated, while the difficulty of valuing property makes the drop less scary: until such time you need to realise the investment when, as many people have been finding out, the downside can be pretty horrible.

Gearing, Property and Shares

The main advantage and downside of property over shares for the unsophisticated investor is gearing: by borrowing money to buy the effects of price gains and losses are magnified. In typical behaviourally biased fashion most people will buy in while markets are surging, not realising that prices can fall sharply and painfully. As usual (due to issues we saw in Retirees, Procrastinate At Your Peril) the short term focus on immediate costs over future ones leads buyers to worry only about the initial affordability rather than the long term liability.

In the end, of course, if property is undervalued compared to shares then the rational investor will sell shares and buy property. The problem is that unlike shares, where re-pricing can occur rapidly, it can take a very, very long time for house prices to adjust after either a boom or a bust. This too is simple behavioural bias – loss aversion triggering (as discussed in Loss Aversion Affects Tiger Woods, Too), meaning people won’t sell at less than some anchoring point: their purchase price, or the selling price achieved by the family next door at the height of the boom.

Behavioural Benefits of Housing

On the other hand the unwillingness of people to sell below their anchor price and the opaqueness of pricing does have the benefit that most home owners won’t get panicked into selling at the bottom, unlike many stock holders. In both cases there’ll be unfortunate forced sellers at the worst possible moment but generally if you have to hold one or the other most private investors would – psychologically – be better off holding housing.

Even so, at the height of the latest Anglo-Saxon inspired housing boom many ‘investors’ were buying second and third homes on which the rental income couldn’t even cover their mortgage costs. Just like with shares, relying on short-term capital appreciation to make an investment worthwhile is a dangerous gamble. A rental property with earnings that more than covers its costs is a safe bet no matter what markets do: if investors applied the same principles to shares they’d be a lot better off, in the main.

As Safe As Houses?

There is strangely little research into behavioural finance effects on the property market, although it’s quite clear that the same sorts of biases that affect stockmarket investors also impact property speculators. What little there is, is surveyed in this this paper by Rohit Kishore. It’s noteworthy, if not especially surprising, that the price achieved at the end of a negotiation is nearly always anchored on the initial price proposed. This isn’t an especially remarkable finding, given that this is usually what the sellers are demanding, but it does suggest that getting your bid in first is the critical thing. However, the caveat is that if the price is set too high there are no offers at all – as many people have found out to their cost, recently.

Those eleventh century barons who were only interested in protecting their own rights have a lot to answer for, but at least the only thing depriving us of our homes these days is our own behavioural incompetence. Sadly no amount of legal precedent is likely to overcome that.


Related Articles: Gold!, Dear Auntie, Why Are My Bonds Bubbling?, Going Dutch, The Benefits of Sound Money

Thursday, 24 September 2009

Cyclical Growth, Form and Fibonacci

Ancient Ideas, Modern Setting

As an up-to-date in-your face sort of blog we like to make sure our readers are well informed about the financial world as we see it. So, starting back in Ancient India in 200BC and taking in medieval Italy and some early twentieth century anti-Darwinian evolutionary thinking let’s take a look at plant growth and snail shells, how twentieth century humanity’s inclination to see the Man in the Moon translates into modern financial theory and why physics may simply be wishful thinking.

At the root of this journey is a simple mathematical progression named after a man who never discovered it and was more concerned with accountancy than trading. Still, he’s still remembered a millennium after his death, which is more than most of us can ever aspire to.

The Golden Ratio

In 1202 the Italian mathematician Leonardo of Pisa, aka Fibonacci, wrote Liber Abaci, a book which has three claims to fame in financial circles. Firstly it was one of the first books to introduce the Arabic numbering system to the West. Secondly it laid out the foundations of modern bookkeeping. Thirdly it presented the number pattern known as the Fibonacci sequence, although this had been known long before by Indian mathematicians. Only the latter has little significance in the development of science and business but, naturally, it’s the one that’s received the most attention.

The Fibonacci sequence is that that which starts with 0 and 1 and proceeds by adding the previous two numbers in the sequence to create the next one. So you get: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc, etc. Divide any Fibonacci number by the one below it and, as you get higher up the sequence, you get closer and closer approximations to the so-called golden ratio of 1:1.618.

Fibonacci in Living Form

As a piece of pure mathematics the sequence is unremarkable until you start digging around in the real world and find it appears regularly in nature. It can be found in many forms – in the arrangements of leaves around a stem, in the structure of sunflowers and pine cones and the shape of snail shells. The appearance of the golden ratio in nature has led many people to suspect that it embodies some kind of mystical significance. These people are idiots, of course, but idiocy has never been a bar to success in this world.

The true explanation for the presence of the Fibonacci sequence in nature was provided by D’Arcy Thompson back at the beginning of the twentieth century. In an age where evolution was accepted but the genetic code underlying it was not widely known Thompson was not alone in trying to find alternative explanations for natural selection. In the unique and beautifully written On Growth and Form he showed how many of nature’s creatures were adaptations of simple geometry rather than difficult evolutionary changes.

Essentially, Thompson argued that there were a few geometric forms suitable to life on Earth and by changing the morphology of these you could explain the majority of physical animal shapes. As an example, he showed how changing a few physical parameters could generate the whole range of different crab shapes found in nature. On a similar note, he showed how the golden ratio is the best physical adaptation to the shape of snail shells.

Order Out of Chaos

The existence of Fibonacci sequences and the golden ratio in nature is therefore not the result of some divinely inspired meddling but the process of natural selection figuring out the best forms for survival. It so happens that Fibonacci numbers offer the most optimal form of growth or packing for certain creatures and that natural selection has, though its normal process of trial and error, figured this out. It’s not that the golden ratio is “out” there, it’s simply that nature finds an efficient way of managing its resources to best effect.

Indeed the golden ratio is a trend rather than a fixed rule. Many flowers, for instance, don’t use Fibonacci numbers and the oft-quoted “fact” that the golden ratio defines the proportions of a human is simply wrong. In fact, judging by the preference of artists down the ages, it’s not even the preferred ratio of human beauty. Statements alleging that the golden ratio is everywhere and unavoidable are, simply, nonsense propagated by mystics and financial theoreticians. Not that there’s much difference between the two, usually.

Elliot Waving Not Drowning

The appearance of this mathematical sequence in nature, however, convinced many people that there was something special about it. As we’ve seen in recent times there’s no industry more attracted to mathematical solutions to complex problems than the financial sector and this isn’t simply a recent trend. The search for the magic formula for making money with no risk and less brainpower has been around for about as long as money has.

Back in the 1930’s Ralph Nelson Elliot developed a technique for forecasting market price movements which he, at some point, decided was based on the Fibonacci sequence. The principle of the Elliot Wave is that collective human psychology drives moves from mass optimism to mass pessimism and then back again. In Elliot’s reconstruction the ebb and flow of the markets is done in an eight step process, five up and three down, ranging over timescales from minutes to a grand supercycle of multiple centuries. According to Elliot the Fibonacci numbers simply appeared out of his theory, although there’s no known underlying principle to explain this. It’s just the way the world works, presumably: shake your chakra, baby.

For reasons we don’t quite understand humanity seems to have a drive to see cyclical behaviour in nature. Going all the way back to Ancient Greece the circle was viewed as the symbol of perfection and a whole model of physics was generated out of this, complete with circular orbits around the Earth. When the universe failed to play ball with the theory, by making planets seen from the Earth go backwards the scientists naturally refused to change their theory and instead developed an elaborate and wondrous system of epicycles, circles within circles.

Epicycles in Finance

Of course, the model was wrong, being based on a false premise, just as models of stockmarket behaviour based on Fibonacci sequences are wrong. The golden ratio exists in nature because it’s the optimal solution to specific problems, not because the universe is designed that way. Our projection of pure mathematics onto the universe’s haphazard geometric best fit engineering solution seems like as good a metaphor as any for the way that modern physics is trying to understand how our universe is put together. Instead, maybe it’s just the only way of making the damn thing work.

In Elliot’s work and the development of multiple other stockmarket cycles – Kitchin, Kuznets, Kondratieff – we see humanity trying to impose order onto chaos. It’s in our nature to try to find patterns, because we’re pattern matching creatures: it’s our way of structuring the world around us. Sadly this often plays us wrong, causing us to see a Man in the Moon, castles in the clouds and cycles in stockmarkets.

Spurious Stockmarket Structures

Many of the more recent market failures have been caused by attempts to model stockmarkets on the assumption that there’s structure underlying them. This spurious quest for structure and precision where none really exists is dangerous for investors. From time to time any theory will work – possibly because enough people believe it, possibly by chance. Inevitably, however, all theories will melt into oblivion in the crucible of market madness.

Those ancient Indian mathematicians knew a thing or two, but they didn’t know about stockmarkets. Remember – the truth isn’t out there, it’s inside us. Trusting in invisible sequences in random systems won’t always be successful, even if those sequences genuinely appear in nature. Systems including humanity will never obey nature’s simple physical laws.


Related Articles: Technical Analysis, Killed By Popularity, Correlation Is Not Causality (And Is Often Spurious), Gaming The System

Sunday, 17 May 2009

The End of the Age of Retirement

Bismarck’s Pension Policy

In 1889 Otto von Bismarck’s German government introduced the first old age pension scheme providing retirement benefits to people over 70, later reduced to 65. The aim of this wasn’t to provide a deserved holiday for old folks at the end of their lives but to ensure a safety net for those made incapable of working by the disabilities of extreme age. At the time the average Prussian lived to 45.

Since then, while lifespans have increased and the likelihood of illness in early retirement has declined, the retirement age hasn’t changed. In the developed world, where the most generous pension entitlements are offered, bitter demographic reality will soon see the end of the Age of Retirement: the idea that people stopped work and had a holiday before they died will one day seem like a curious feature of our peculiar times.

Tuesday, 12 May 2009

Copper at Morewellham Quay

Victorian Copper

As you gaze around the tiny Devon hamlet of Morwellham Quay, fifteen miles up the River Tamar, deep in an area of outstanding natural beauty, it’s hard to imagine you’re standing at the gateway to the biggest copper mine in Queen Victoria's far flung empire. By 1850 Morwellham Quay was a more important port than Liverpool yet within a few decades the port was subsiding into ruin, from which it’s only now re-emerging as an industrial archaeology site and post-industrial tourist attraction.

Once this leafy backwater was a blasted and desolate wilderness – the pollution generated by the multiple mines along the Tamar turning what is now a green, leafy beauty spot into a Hell on Earth. All because of the most precious base metal of them all, copper.

Sunday, 5 April 2009

Regression to the Mean: Of Nazis and Investment Analysis

Francis Galton, The Measuring Man

Francis Galton, cousin of Charles Darwin, was utterly uninterested in the both the workings of investment analysts and Hitler’s future plans for world domination. To be fair he died before both really got going. However, he has the dubious distinction of being at least partially to blame for some of the madder excesses of both.

What Galton was interested in was measuring things: mainly people, although he’d turn his hand to anything in the absence of a likely suspect or two. In so doing he uncovered a statistical phenomenon known as Regression to the Mean which lies behind many of the theories which still dominate stockmarket analysis and valuation techniques today and which many people misunderstand totally.

Tuesday, 31 March 2009

Going Dutch, The Benefits of Sound Money

Dutch Cunning

In the second half of the seventeenth century the tiny Dutch Republic was besieged by all of the great nations of the time. Yet, despite being continually faced with invasion by Spain and France and naval blockade by England, the Hollanders survived and prospered aided by a cunning and thoroughly deceitful strategy.

They always paid their debts.

Sunday, 1 March 2009

Sir Hugh Invents the Share and Gets Lost

What's a Share?

In 1553 Sir Hugh Willoughby set sail from England to Russia with the intention of opening the first trade route between the two countries. The idea behind his venture, the Muscovy Company or, to give it its full name (deep breath) The Mystery and Company of Merchant Adventurers for the Discovery of Regions, Dominions, Islands, and Places unknown, wasn’t unusual for the time. All across Europe explorers and merchants were sailing into the unknown in a quest for fame and, particularly, fortune.

The Muscovy Company, though, was unusual in another way. It was the first recognisably modern corporation.