There seems to be consensus that conventional economic models did a poor job predicting the magnitude of the last crisis and that we need to do better. In today's Wall Street Journal, we see the beginnings of one response:
http://online.wsj.com/article/SB10001424052702303891804575576523458637864.html?mod=WSJ_economy_LeftTopHighlights
In short, a physicist, a psychoanalyst and an economist believe that they can build a bigger model that captures the complexities of the real world and does a better job of forecasting the future. Good luck with that! While I wish them well, my response is that this will go nowhere or worse, go somewhere bad.
To those who believe that complex models with more variables are the answer to uncertainty, my response is a paper by Ed Lorenz in 1972, entitled Predictability: Does the flap of a butterfly's wing in Brazil set off a tornado in Texas?, credited with creating an entire discipline: chaos theory. In the paper, Lorenz noted that very small changes in the initial conditions of a complex models created very large effects on the final forecasted values. Lorenz, a meteorologist, came to this recognition by accident. One day in 1961, Lorenz inputted a number into a weather prediction model; he entered 0.506 as the input instead of 0.506127, expecting little or no change in the output from the model. What he found instead was a dramatic shift in the output, giving rise to a Eureka moment and the butterfly effect. (One of my favorite books on the topic of Chaos is by James Gleick. It is an easy read and well worth the time.. for investors and economists)
Complex models work best with inputs that behave in thoroughly predictable ways: software and engineering models come to mind. They break down when the inputs are noisy and the relationships are unstable: macro economic models are perfect lab experiments for chaos. The subjects (human beings) belong in strange and unpredictable ways, the variables that matter keep shifting and the relationships between them change over time. In fact, I will wager that the models that worked worst during the last crisis were the most complex models with dozens of inputs and cross relationships.
So, what is the solution? My experience in valuation suggests that you should go in the other direction. When faced with more uncertainty, strip the model down to only the basic inputs, minimize the complexity and build the simplest model you can. Take out all but the key variables and reduce detail. I use this principle when valuing companies. The more uncertainty I face, the less detail I have in my valuation, recognizing that my capacity to forecast diminishes with uncertainty and that errors I make on these inputs will magnify as they percolate through the valuation. More good news: if I am going to screw up, at least I will do so with a lot less work!!
Tuesday, 30 November 2010
Wednesday, 24 November 2010
The insider trading scandal: Thoughts about the hedge fund business
As many of you are aware, the last week has been filled with news stories about imminent arrests in an insider trading scandal that supposedly entangles multiple hedge funds and bankers at a couple of large investment banks. I am being leery about naming names, even though they are now in the public domain, since these selective leaks can be devastating not only to the individuals named but also to the entities that they represent. While some may feel that "they" deserve this, I think we still live in a country where you are innocent until proven guilty.
So, I am going to use this story to talk about a bigger question. Not insider trading, because I have put my views on the topic down in a previous blog post, but about the hedge fund business. Note that many of the targets in this investigation are hedge fund managers. Since I have no reason to believe that hedge fund managers are any more immoral or unethical than any other random group of money managers, the question then becomes: What is it about the hedge fund business that seems to drive this constant search for an information edge? Or why do we not see more traditional mutual fund managers involved in these scandals?
At first sight, hedge funds and mutual funds share much in common. They both solicit money from investors, promising to deliver above-market returns to them and they get compensated for managing this money. But there are three significant differences:
1. Constraints on investing: Mutual funds are far more constrained in where and how they invest than most hedge funds are. Some of these constraints are imposed by regulators, some are self imposed and some are the created by clients.
a. Long versus long/short strategies: Most mutual funds can only buy stocks (The Investment Company Act of 1940 that governs mutual funds puts significant restrictions on short sales by funds), whereas hedge funds often can both sell short on some stocks and go long on others.
b. Investment choices: There are several mutual funds that are judged based on "tracking error", measured by how far their returns deviate from a specified index's return. This constraint, usually imposed by clients, is designed to prevent fund managers from straying too far from the companies in the index. Hedge funds generally can invest not only in whatever company they want but many invest across asset classes.
2. Clientele mix: Hedge funds attract investments from either the very wealthy or institutions (pension funds, for instance). In fact, most of them actively discourage small, individual investors by requiring a large, minimum investment. Mutual funds tend to attract individual investors. At the risk of a gross generalization, institutional and wealthy investors are more demanding than individual investors; they move their money out of loser funds and into hot funds far more quickly than other individuals do. Put another way, if the herding effect is a phenomenon that affects all investors, it seems to affect wealthier and institutional investors more. (Some hedge funds put withdrawal restrictions on investors to counter.)
3. Financial leverage: Hedge funds are far more likely to use borrowed money to lever their bets. Most mutual funds either do not borrow money or do so on a very restrictive basis.
4. Compensation systems: Mutual funds generally make their money in two ways. All mutual funds cover their expenses from the money under management; the management; these management expenses are public information and can be accessed at services like Morningstar. A subset of funds also assess a one-time up-front sales charge (load), when you invest, where a certain percent of what you invest is taken by the fund at the time of the investment. Hedge funds assess an annual load (1% or 2% of the invested amount each year) and a percentage of the profit on the investment (10 or 20% of the profits).
You may be wondering at this stage what all of this has to do with insider trading. Consider why people seek out insider information. If they succeed, they can buy or sell a stock prior to that information becoming public; when it goes public, the stock will pop up or down, depending on whether the information is good or bad news.
All four differences highlighted play into why hedge fund managers see more gain from seeking out and exploiting private information:
In closing, though, I am not sure that all of this seeking out of information is generating a payoff for hedge funds. In the aggregate, they continue to either match or under perform actively managed mutual funds (which, in turn, under perform index funds), when fees and transactions costs are factored in. It is entirely possible that some of the "super" performers among hedge funds got there because they had access to private information that no one else had. I just don't think it is likely! As Shakespeare would put it, this seems like much ado about nothing!
So, I am going to use this story to talk about a bigger question. Not insider trading, because I have put my views on the topic down in a previous blog post, but about the hedge fund business. Note that many of the targets in this investigation are hedge fund managers. Since I have no reason to believe that hedge fund managers are any more immoral or unethical than any other random group of money managers, the question then becomes: What is it about the hedge fund business that seems to drive this constant search for an information edge? Or why do we not see more traditional mutual fund managers involved in these scandals?
At first sight, hedge funds and mutual funds share much in common. They both solicit money from investors, promising to deliver above-market returns to them and they get compensated for managing this money. But there are three significant differences:
1. Constraints on investing: Mutual funds are far more constrained in where and how they invest than most hedge funds are. Some of these constraints are imposed by regulators, some are self imposed and some are the created by clients.
a. Long versus long/short strategies: Most mutual funds can only buy stocks (The Investment Company Act of 1940 that governs mutual funds puts significant restrictions on short sales by funds), whereas hedge funds often can both sell short on some stocks and go long on others.
b. Investment choices: There are several mutual funds that are judged based on "tracking error", measured by how far their returns deviate from a specified index's return. This constraint, usually imposed by clients, is designed to prevent fund managers from straying too far from the companies in the index. Hedge funds generally can invest not only in whatever company they want but many invest across asset classes.
2. Clientele mix: Hedge funds attract investments from either the very wealthy or institutions (pension funds, for instance). In fact, most of them actively discourage small, individual investors by requiring a large, minimum investment. Mutual funds tend to attract individual investors. At the risk of a gross generalization, institutional and wealthy investors are more demanding than individual investors; they move their money out of loser funds and into hot funds far more quickly than other individuals do. Put another way, if the herding effect is a phenomenon that affects all investors, it seems to affect wealthier and institutional investors more. (Some hedge funds put withdrawal restrictions on investors to counter.)
3. Financial leverage: Hedge funds are far more likely to use borrowed money to lever their bets. Most mutual funds either do not borrow money or do so on a very restrictive basis.
4. Compensation systems: Mutual funds generally make their money in two ways. All mutual funds cover their expenses from the money under management; the management; these management expenses are public information and can be accessed at services like Morningstar. A subset of funds also assess a one-time up-front sales charge (load), when you invest, where a certain percent of what you invest is taken by the fund at the time of the investment. Hedge funds assess an annual load (1% or 2% of the invested amount each year) and a percentage of the profit on the investment (10 or 20% of the profits).
You may be wondering at this stage what all of this has to do with insider trading. Consider why people seek out insider information. If they succeed, they can buy or sell a stock prior to that information becoming public; when it goes public, the stock will pop up or down, depending on whether the information is good or bad news.
All four differences highlighted play into why hedge fund managers see more gain from seeking out and exploiting private information:
- Hedge funds can exploit both good news and bad news, by buying stocks in advance of the former and selling short ahead of the latter. Mutual funds can only buy on good news (though they can sell any existing holdings of companies on which bad news lies ahead).
- While money management at any level is a rat race, where funds try to keep their own clients and coax clients away from their competitors, the race becomes more frenetic with hedge funds. A hedge fund that lags its peer group can enter a death spiral, where losses spur withdrawals which feed into more losses.
- If the "inside information" is precise, you can use even more debt in your investment strategy, creating huge payoffs on your investment, when the information becomes public. Financial leverage acts as a multiplier on profits from insider trading.
- The compensation system at hedge funds essentially gives every hedge fund manager a call option: they make 10 or 20% of all profits, no matter how large, and do not share in losses. Trading on information ties in well with this system, since it delivers skewed returns: most of the time, information turns out to be worthless, but when it is relevant information, the payoff is very large. Thus, even if insider information is noisy and provides little benefits or even creates costs for investors over the long term, hedge fund managers may still benefit personally from its use because of the upside call built into their compensation systems...
In closing, though, I am not sure that all of this seeking out of information is generating a payoff for hedge funds. In the aggregate, they continue to either match or under perform actively managed mutual funds (which, in turn, under perform index funds), when fees and transactions costs are factored in. It is entirely possible that some of the "super" performers among hedge funds got there because they had access to private information that no one else had. I just don't think it is likely! As Shakespeare would put it, this seems like much ado about nothing!
Sunday, 21 November 2010
Social Network for Fashion raises $millions in finance
Tumblr a online business— which has been compared to Facebook and previously attracted just over $10 million with their business plan from Spark Capital and Union Square Ventures (both key investors in Twitter) — was recently able to raise between $25 million and $30 million in additional business financing, valuing the business at an estimated $135 million. Famed Silicon Valley VC firm Sequoia Capital was the lead investor. “I will say, it is nice to be well-received on the West Coast,” Tumblr’s president, John Maloney, told Business Insider.
According to comScore, microblogging platform Tumblr hit an “inflection point” sometime last June. Page views on Tumblr.com — which lets users create mixed-media blog posts with the kind of extreme simplicity and immediacy not found in traditional blogging platforms — began to surge. By October 2010, page views in the U.S. were up a staggering 1,540 percent from the year before. According to the New York-based company, Tumblr now has 47 million unique visitors per month, 2.7 billion page views per month, and over 9 million users, with approximately 30,000 new users joining the platform every day.
Interestingly, Tumblr has been very well-received in the fashion community, as well, giving rise to a universe of fashion-related microblogs. “Over the past year, fashion has emerged as one of the fastest growing segments of the Tumblr community, with 20% of our top 1000 blogs related to fashion,” said Rich Tong, a co-founder of Weardrobe (sold to Like.com in 2009) and Tumblr’s new fashion director.
It’s not surprising then that Tumblr founder David Karp told TechCrunch last week that Tumblr wants to be “the best place in the world for the best creative communities,” with fashion at the core of this focused strategy.
Many of the most popular fashion Tumblrs are personal style blogs like whatiwore and triciawillgoplaces, vintage and craft-focused blogs like psimadethis and hawtvintage, and street style blogs like fuckyeahstreetstyle and lookbookdotnu, launched by the eponymous look-sharing site. But a recent post on Refinery29 entitled “The Best Fashion Tumblrs To Follow Now” reflects the striking diversity of fashion blogs that have sprung up since the platform was launched in 2007. The list includes shoelust, theimpossiblecool, and textbook, a Tumblr dedicated to answering the question “What would Holden Caulfield wear?”
Industry insiders have embraced the platform as well. Purple Fashion editor Olivier Zahm and photographer Terry Richardson, for example, both use Tumblr to publish informal, spontaneous and highly popular personal diaries, Purple Diary and Terry’s Diary.
On one level, Tumblr has struck a chord with the fashion community because, like fashion itself, the platform is both immediate and highly-visual. While Tumblr posts can be text, images, quotes, links, chats, audio clips or videos, 50% of all posts are photos. “As a platform Tumblr is almost purely visual,” said Francine Ballard, founder and editorial director of Designer Social, an online showroom that operates a Tumblr. “Most of what gets reblogged is prompted by a sort-of visceral response. So by definition, it has the potential to be a fantastic medium for fashion.”
Indeed, Tumblr has found particular resonance amongst fashion creatives, who use the platform to aggregate and share the inspiration they find online. “I use Tumblr as a way for my creative team to share things that they are inspired by,” said Diana Hong, creative director at digital fashion agency CreateThe Group and an early adoptor of the platform.
Tavi Gevinson, best known for her blog The Style Rookie, also maintains a microblog called Slow Motion Crawl, which she migrated from Blogspot to Tumblr early last year. “It’s much more informal, more for archiving and self-reference than anything else. My favorite thing is how convenient it is for storing inspiration — when I compile images for a post on Style Rookie, I usually find them all in my Tumblr archives.”
But as well as being radically visual, quick and convenient — a Tumblr bookmarklet, as well as Tumblr mobile apps for Blackberry, iPhone and Android, make it incredibly simple to share content — Tumblr is fundamentally different from traditional blogging platforms because it comes with a built-in community. On Tumblr, users can “follow” and “reblog” other bloggers, whose posts appear in realtime streams on a Tumblr “dashboard,” much like on Twitter.
“It’s so addictive because you follow your favourite Tumblrs, which give you the best of the internet, so you just keep clicking through your dashboard and finding more and more that you like,” said Tavi.
“Tumblr seems to now have an audience of regular users and we decided it would be beneficial to drive traffic back to the site, as well as being a source of inspiration,” said Alistair Allan, digital director at Dazed Group, which operates popular fashion, art and music website Dazed Digital and, last month, launched dazeddigital.tumblr.com, a Tumblr that highlights favourite items from Dazed Digital each day.
“Many publications primarily care about Tumblr as a traffic driver, but we’ve noticed that the ones who use Tumblr to express a point of view are the ones who succeed within the community,” said Tumblr’s Mr. Tong, commenting on the Dazed Digital offering. “Once they do that, the traffic takes care of itself.”
Notably, Tumblr has managed to attract a passionate community that’s largely composed of young and influential, design-focused people. For fashion media brands, this is an extremely attractive, high-value demographic who have an almost insatiable appetite for content and share their discoveries with their social graph, both on Tumblr and across the web. “Our community loves original content — and loves reblogging it straight from the source,” said Mr. Tong.
Conveniently, a Facebook app and publish to Twitter feature neatly integrate Tumblr into the two most important social networks on the internet, enabling the platform’s influential userbase to easily distribute content to friends and followers.
It’s no surprise, then, that major fashion publishers like Vogue and Elle have recently launched Tumblrs. “The demographics of the Tumblr audience are very much in line with the demographics of our readers: typically young, fashion-minded people with a strong appreciation for pop culture,” said Keith Pollock, editorial director of Elle.com.
The platform also allows fashion media brands to speak to consumers in a softer, more personal tone. “Tumblr provides a great opportunity for brands and publishers to step out of their strict editorial guidelines and create a down to earth, approachable voice,” said Mr. Tong. What’s more, Tumblr makes it easy to establish the kind of genuine reciprocal relationships that turn fans and followers into brand loyalists. “By following users you think create great content, liking their posts and reblogging their content as well, you establish a very passionate and loyal following,” explained Mr. Tong.
But it’s not just media companies who are getting in on the action. LVMH-backed ethical fashion brand Edun operates a Tumblr called Eye of Edun, where the company shares behind the scenes imagery and visual inspiration. “Tumblr is embraced by artists and creative communities more so than other blogging platforms,” said Edun’s brand director Bianca Barattini. “Edun.com tells our entire story, from backstory to mission and offers a shopping experience, while the Tumblr is purely inspiration.”
But it may not be long before fashion brands start to integrate commerce into their Tumblrs. Last Thursday, a small startup called Of a Kind, which offers limited edition items from emerging designers, became the first store to launch on Tumblr. “Building our site on Tumblr seemed like an obvious move — it has allowed us to put our content in front of early adopters in a place where they were already congregating,” said co-founder and president Erica Cerulo. Tumblr does not technically support e-commerce, but Of a Kind was able to easily connect their Tumblr to Shopify, a simple digital commerce app, to offer a fully shopable experience.
Asked if Tumblr would be adding e-commerce functionality in the future, Mr. Tong responded: “We haven’t yet pursued supporting that feature set, but given the virality of our network, we’re definitely exploring ideas on how best to integrate the e-commerce component into our user experience.”
With the possibility of commerce-enabled Tumblrs on the horizon, the existing opportunities for content distribution and audience engagement, and the minimal time and effort it actually takes to start blogging on Tumblr, we suspect it won’t be too long before smart fashion brands see Tumblr as an indispenable tool in their social media arsenal, alongside Twitter and Facebook.
If fashion and creative communities are at the heart of Tumblr, BoF must be there too. You can now follow us on Tumblr: businessoffashion.tumblr.com
Vikram Alexei Kansara is Managing Editor of The Business of Fashion.
According to comScore, microblogging platform Tumblr hit an “inflection point” sometime last June. Page views on Tumblr.com — which lets users create mixed-media blog posts with the kind of extreme simplicity and immediacy not found in traditional blogging platforms — began to surge. By October 2010, page views in the U.S. were up a staggering 1,540 percent from the year before. According to the New York-based company, Tumblr now has 47 million unique visitors per month, 2.7 billion page views per month, and over 9 million users, with approximately 30,000 new users joining the platform every day.
Interestingly, Tumblr has been very well-received in the fashion community, as well, giving rise to a universe of fashion-related microblogs. “Over the past year, fashion has emerged as one of the fastest growing segments of the Tumblr community, with 20% of our top 1000 blogs related to fashion,” said Rich Tong, a co-founder of Weardrobe (sold to Like.com in 2009) and Tumblr’s new fashion director.
It’s not surprising then that Tumblr founder David Karp told TechCrunch last week that Tumblr wants to be “the best place in the world for the best creative communities,” with fashion at the core of this focused strategy.
Many of the most popular fashion Tumblrs are personal style blogs like whatiwore and triciawillgoplaces, vintage and craft-focused blogs like psimadethis and hawtvintage, and street style blogs like fuckyeahstreetstyle and lookbookdotnu, launched by the eponymous look-sharing site. But a recent post on Refinery29 entitled “The Best Fashion Tumblrs To Follow Now” reflects the striking diversity of fashion blogs that have sprung up since the platform was launched in 2007. The list includes shoelust, theimpossiblecool, and textbook, a Tumblr dedicated to answering the question “What would Holden Caulfield wear?”
Industry insiders have embraced the platform as well. Purple Fashion editor Olivier Zahm and photographer Terry Richardson, for example, both use Tumblr to publish informal, spontaneous and highly popular personal diaries, Purple Diary and Terry’s Diary.
On one level, Tumblr has struck a chord with the fashion community because, like fashion itself, the platform is both immediate and highly-visual. While Tumblr posts can be text, images, quotes, links, chats, audio clips or videos, 50% of all posts are photos. “As a platform Tumblr is almost purely visual,” said Francine Ballard, founder and editorial director of Designer Social, an online showroom that operates a Tumblr. “Most of what gets reblogged is prompted by a sort-of visceral response. So by definition, it has the potential to be a fantastic medium for fashion.”
Indeed, Tumblr has found particular resonance amongst fashion creatives, who use the platform to aggregate and share the inspiration they find online. “I use Tumblr as a way for my creative team to share things that they are inspired by,” said Diana Hong, creative director at digital fashion agency CreateThe Group and an early adoptor of the platform.
Tavi Gevinson, best known for her blog The Style Rookie, also maintains a microblog called Slow Motion Crawl, which she migrated from Blogspot to Tumblr early last year. “It’s much more informal, more for archiving and self-reference than anything else. My favorite thing is how convenient it is for storing inspiration — when I compile images for a post on Style Rookie, I usually find them all in my Tumblr archives.”
But as well as being radically visual, quick and convenient — a Tumblr bookmarklet, as well as Tumblr mobile apps for Blackberry, iPhone and Android, make it incredibly simple to share content — Tumblr is fundamentally different from traditional blogging platforms because it comes with a built-in community. On Tumblr, users can “follow” and “reblog” other bloggers, whose posts appear in realtime streams on a Tumblr “dashboard,” much like on Twitter.
“It’s so addictive because you follow your favourite Tumblrs, which give you the best of the internet, so you just keep clicking through your dashboard and finding more and more that you like,” said Tavi.
“Tumblr seems to now have an audience of regular users and we decided it would be beneficial to drive traffic back to the site, as well as being a source of inspiration,” said Alistair Allan, digital director at Dazed Group, which operates popular fashion, art and music website Dazed Digital and, last month, launched dazeddigital.tumblr.com, a Tumblr that highlights favourite items from Dazed Digital each day.
“Many publications primarily care about Tumblr as a traffic driver, but we’ve noticed that the ones who use Tumblr to express a point of view are the ones who succeed within the community,” said Tumblr’s Mr. Tong, commenting on the Dazed Digital offering. “Once they do that, the traffic takes care of itself.”
Notably, Tumblr has managed to attract a passionate community that’s largely composed of young and influential, design-focused people. For fashion media brands, this is an extremely attractive, high-value demographic who have an almost insatiable appetite for content and share their discoveries with their social graph, both on Tumblr and across the web. “Our community loves original content — and loves reblogging it straight from the source,” said Mr. Tong.
Conveniently, a Facebook app and publish to Twitter feature neatly integrate Tumblr into the two most important social networks on the internet, enabling the platform’s influential userbase to easily distribute content to friends and followers.
It’s no surprise, then, that major fashion publishers like Vogue and Elle have recently launched Tumblrs. “The demographics of the Tumblr audience are very much in line with the demographics of our readers: typically young, fashion-minded people with a strong appreciation for pop culture,” said Keith Pollock, editorial director of Elle.com.
The platform also allows fashion media brands to speak to consumers in a softer, more personal tone. “Tumblr provides a great opportunity for brands and publishers to step out of their strict editorial guidelines and create a down to earth, approachable voice,” said Mr. Tong. What’s more, Tumblr makes it easy to establish the kind of genuine reciprocal relationships that turn fans and followers into brand loyalists. “By following users you think create great content, liking their posts and reblogging their content as well, you establish a very passionate and loyal following,” explained Mr. Tong.
But it’s not just media companies who are getting in on the action. LVMH-backed ethical fashion brand Edun operates a Tumblr called Eye of Edun, where the company shares behind the scenes imagery and visual inspiration. “Tumblr is embraced by artists and creative communities more so than other blogging platforms,” said Edun’s brand director Bianca Barattini. “Edun.com tells our entire story, from backstory to mission and offers a shopping experience, while the Tumblr is purely inspiration.”
But it may not be long before fashion brands start to integrate commerce into their Tumblrs. Last Thursday, a small startup called Of a Kind, which offers limited edition items from emerging designers, became the first store to launch on Tumblr. “Building our site on Tumblr seemed like an obvious move — it has allowed us to put our content in front of early adopters in a place where they were already congregating,” said co-founder and president Erica Cerulo. Tumblr does not technically support e-commerce, but Of a Kind was able to easily connect their Tumblr to Shopify, a simple digital commerce app, to offer a fully shopable experience.
Asked if Tumblr would be adding e-commerce functionality in the future, Mr. Tong responded: “We haven’t yet pursued supporting that feature set, but given the virality of our network, we’re definitely exploring ideas on how best to integrate the e-commerce component into our user experience.”
With the possibility of commerce-enabled Tumblrs on the horizon, the existing opportunities for content distribution and audience engagement, and the minimal time and effort it actually takes to start blogging on Tumblr, we suspect it won’t be too long before smart fashion brands see Tumblr as an indispenable tool in their social media arsenal, alongside Twitter and Facebook.
If fashion and creative communities are at the heart of Tumblr, BoF must be there too. You can now follow us on Tumblr: businessoffashion.tumblr.com
Vikram Alexei Kansara is Managing Editor of The Business of Fashion.
Friday, 19 November 2010
How do you evaluate risk taking?
The GM IPO is the news of the week. The fact that GM has been able to go public and that the government may not only get its money back on its investment but may even make a profit has led to some celebration in the White House:
http://www.whitehouse.gov/photos-and-video/video/2010/11/18/president-obama-gm-ipo
I don't begrudge the White House its victory dance that the GM bet looks like it has paid off, but it is an auspicious moment to examine how we judge risk taking, in general. As I see it, risk taking can be judged on four dimensions.
1. Outcome: The nature of risk taking is that you win some of the time and lost some.... It is human nature to judge the quality of risk taking by looking at the outcome of the risk taking. Success is thus vindication and failure is calamity. If you follow this to its logical ends, if you succeed, you are a good risk taker and if you fail, you are not. This is the theme that is being tapped into by both Warren Buffet when he wrote his thank you note to the government for TARP and by the White House for its GM investment. "Things worked out well in the end... So, it must have been a sensible decision up front"...
2. Process: A more complicated way of judging risk taking is to look at whether the risk taking made sense at the time that the risk was taken, with the information available at the time, rather than with the benefit of hindsight. At least in theory, it is possible that even the best-deliberated risky decisions can have bad outcomes, if fate does not cooperate, and that terrible choices when faced with risk can have "good" outcomes. Playing devil's advocate, however, it is much more difficult and more work to evaluate process than outcome.
3. Side costs and benefits:When risk taking creates costs and benefits for others, judging risk taking by its outcome for just the risk taker may not be fair, since it is conceivable for risk takers to make money while creating costs for society. It is also possible for risk taking activity to create losses for the risk takers while generating benefits for society. A fair assessment of risk taking will require us to consider these side costs and benefits into account.
4. Future risk taking behavior:It should not be surprising that how we take and reward/punish risk taking in the present can affect how people take risks in the future. If risk taking of a certain type consistently is rewarded, you will see more of it in the future. If in contrast, risk taking of a different type leads to punishment/losses, you will see less of it in the the future. If markets are viewed as "too easy" on risk takers, there will be more risk taking in the future in the future.
When does it make sense to judge risk taking on outcome alone? If a risk taker takes many risks over time and is right on average on a consistent basis and there are no significant side costs and benefits, it is reasonable to argue that success is the result of good risk taking. A portfolio manager who beats the market each year for 10 years must be doing something right in terms of risk taking. However, judging a large risk taking venture with significant side costs and benefits and consequences for future risk taking on whether it makes money or not may not be sensibel.
Returning to the GM investment, the judgment on whether it was successful becomes more nuanced when we consider the other factors, even if the government's original investment makes money.
a. Did the government investment in GM make sense at the time of the investment, given what was known then? Tough to tell, since we do not know what the government knew at the time of the intervention. Given what the rest of us knew at the time, it would have been difficult to justify the billions invested in the company. However, it is possible that the authorities had information about GM's assets and liabilities that we did not. So, I will give the benefit of the doubt to the government on this point.
b. What were the side costs and benefits of the government investment? On the plus side , GM's salvation prevented thousands of layoffs at the company and budgetary chaos at at least one state (Michigan). On the minus side, the government's intervention on GM's behalf has cost other carmakers a chance to make inroads in this market. To the extent that the other car makers are foreign (Toyota or Honda), this may seem like a good thing, but the belief in free markets cannot stop at the borders. It is also conceivable that GM's salvation may have cost Ford a chance to make inroads into the market and secure its position for the long term.
c. What are the long term lessons for risk taking behavior?
It is undeniable that GM made some really bad strategic and management decisions in the the last three decades. In the face of default, the government stepped in, upended bankruptcy and tax laws (which conveniently were written and interpreted by government officials) and saved the company. Other firms that took more prudent decisions in the face of risk were put at a disadvantage. It would seem to me that the lessons learned on risk taking from this experience are the wrong ones: if you take risks, make sure that you are a big firm with the right connections.
Bottom line. As a taxpayer, I am happy that the GM investment looks like it will break even or better.. As an investor, I am less happy about the long term consequences of this success. I am afraid that it sends the wrong signals on risk taking to the market and investors.
http://www.whitehouse.gov/photos-and-video/video/2010/11/18/president-obama-gm-ipo
I don't begrudge the White House its victory dance that the GM bet looks like it has paid off, but it is an auspicious moment to examine how we judge risk taking, in general. As I see it, risk taking can be judged on four dimensions.
1. Outcome: The nature of risk taking is that you win some of the time and lost some.... It is human nature to judge the quality of risk taking by looking at the outcome of the risk taking. Success is thus vindication and failure is calamity. If you follow this to its logical ends, if you succeed, you are a good risk taker and if you fail, you are not. This is the theme that is being tapped into by both Warren Buffet when he wrote his thank you note to the government for TARP and by the White House for its GM investment. "Things worked out well in the end... So, it must have been a sensible decision up front"...
2. Process: A more complicated way of judging risk taking is to look at whether the risk taking made sense at the time that the risk was taken, with the information available at the time, rather than with the benefit of hindsight. At least in theory, it is possible that even the best-deliberated risky decisions can have bad outcomes, if fate does not cooperate, and that terrible choices when faced with risk can have "good" outcomes. Playing devil's advocate, however, it is much more difficult and more work to evaluate process than outcome.
3. Side costs and benefits:When risk taking creates costs and benefits for others, judging risk taking by its outcome for just the risk taker may not be fair, since it is conceivable for risk takers to make money while creating costs for society. It is also possible for risk taking activity to create losses for the risk takers while generating benefits for society. A fair assessment of risk taking will require us to consider these side costs and benefits into account.
4. Future risk taking behavior:It should not be surprising that how we take and reward/punish risk taking in the present can affect how people take risks in the future. If risk taking of a certain type consistently is rewarded, you will see more of it in the future. If in contrast, risk taking of a different type leads to punishment/losses, you will see less of it in the the future. If markets are viewed as "too easy" on risk takers, there will be more risk taking in the future in the future.
When does it make sense to judge risk taking on outcome alone? If a risk taker takes many risks over time and is right on average on a consistent basis and there are no significant side costs and benefits, it is reasonable to argue that success is the result of good risk taking. A portfolio manager who beats the market each year for 10 years must be doing something right in terms of risk taking. However, judging a large risk taking venture with significant side costs and benefits and consequences for future risk taking on whether it makes money or not may not be sensibel.
Returning to the GM investment, the judgment on whether it was successful becomes more nuanced when we consider the other factors, even if the government's original investment makes money.
a. Did the government investment in GM make sense at the time of the investment, given what was known then? Tough to tell, since we do not know what the government knew at the time of the intervention. Given what the rest of us knew at the time, it would have been difficult to justify the billions invested in the company. However, it is possible that the authorities had information about GM's assets and liabilities that we did not. So, I will give the benefit of the doubt to the government on this point.
b. What were the side costs and benefits of the government investment? On the plus side , GM's salvation prevented thousands of layoffs at the company and budgetary chaos at at least one state (Michigan). On the minus side, the government's intervention on GM's behalf has cost other carmakers a chance to make inroads in this market. To the extent that the other car makers are foreign (Toyota or Honda), this may seem like a good thing, but the belief in free markets cannot stop at the borders. It is also conceivable that GM's salvation may have cost Ford a chance to make inroads into the market and secure its position for the long term.
c. What are the long term lessons for risk taking behavior?
It is undeniable that GM made some really bad strategic and management decisions in the the last three decades. In the face of default, the government stepped in, upended bankruptcy and tax laws (which conveniently were written and interpreted by government officials) and saved the company. Other firms that took more prudent decisions in the face of risk were put at a disadvantage. It would seem to me that the lessons learned on risk taking from this experience are the wrong ones: if you take risks, make sure that you are a big firm with the right connections.
Bottom line. As a taxpayer, I am happy that the GM investment looks like it will break even or better.. As an investor, I am less happy about the long term consequences of this success. I am afraid that it sends the wrong signals on risk taking to the market and investors.
Monday, 15 November 2010
Amateur Athletics
This post spans two topics I love - finance and sports- and what triggered it was the hullabaloo over Cam Newton, Auburn's quarterback, and the purported attempts by his father to extract money from Auburn. The National Collegiate Athletic Association (NCAA) will be the ultimate arbiter on whether rules were broken and the penalties that will follow, but this entire debate about college sports strikes me as hypocrisy of the highest order.
Let us start with basic facts. College sports in the United States is big business and big money, generating hundreds of millions of dollars in revenues for the big name colleges, the television networks and bookmakers. I got my MBA and Phd at UCLA and I know that no faculty member at UCLA brought in a fraction of the revenues that the UCLA basketball coach did and none was as widely recognized in campus. In college football, Auburn is ranked second in the country and could very well be playing for a national championship this year. The New York Times has an article on the impact that Cam Newton at quarterback has had on Auburn's economics:
http://www.nytimes.com/2010/11/14/weekinreview/14belson.html
Here comes the hypocrisy. The NCAA likes to maintain the illusion that college sports is not business and that college players are amateurs. While this may in fact be true for most athletes at second and third tier schools, playing lower profile sports, it is certainly not true for college football and basketball at Division I schools. The NCAA then has rigid rules on what college players can receive in return for playing their sports: not only can they not get monetary gifts from the school but the ban extends to cover the most trivial of gifts. From an economic standpoint, this strikes me as a modern version of indentured servitude. If you are a superb basketball or football player, you have to play for a college of your choice (that is the NCAA's concession to free choice) for nothing, before you can play professional football or basketball. The colleges and the networks make millions but the players (who are the stars of the system) get scholarships, worth a few thousands and risk career ending injuries while doing so.
As I watch the "amateur" label debated in college athletics, I am reminded of similar debates that occurred in tennis and the Olympics. For decades, we kept our best tennis players out of the big tournaments in the interests of maintaining the illusion that these tournaments were just for amateurs; I can only imagine how many Wimbledons that Rod Laver would have won, if he had been allowed to play in his prime. For decades, the Olympics forced great sprinters and athletes to pick between being champions and making a living, before bowing to the reality that you cannot win the 100M by practicing just on weekends.
Don't get me wrong. I love college sports, but I think it is time to strip the hypocrisy out. My proposal is that we create two classes of college athletes: The first would be "student athletes", who get scholarships, but focus on taking classes (regular classes, not Mickey Mouse ones) like other students and get college degrees. Some of them may find that they are good enough to become professional, but most of them will play college sports and then move on to bigger and better things in life. The second would be "semi-pro" athletes, who will be allowed to earn an income (we can put caps on the income and restrict what colleges can pay, if need be) while they played and earn money from advertisements and sponsorships. They would be required to be visible on campuses and allowed to take classes, if they choose to. Colleges would also be required to set aside a portion of their revenues to cover the health and personal costs incurred by college athletes. I think I would still enjoy watching UCLA play basketball... while knowing that the Bruins on the court are making a reasonable living while playing the game.
Let us start with basic facts. College sports in the United States is big business and big money, generating hundreds of millions of dollars in revenues for the big name colleges, the television networks and bookmakers. I got my MBA and Phd at UCLA and I know that no faculty member at UCLA brought in a fraction of the revenues that the UCLA basketball coach did and none was as widely recognized in campus. In college football, Auburn is ranked second in the country and could very well be playing for a national championship this year. The New York Times has an article on the impact that Cam Newton at quarterback has had on Auburn's economics:
http://www.nytimes.com/2010/11/14/weekinreview/14belson.html
Here comes the hypocrisy. The NCAA likes to maintain the illusion that college sports is not business and that college players are amateurs. While this may in fact be true for most athletes at second and third tier schools, playing lower profile sports, it is certainly not true for college football and basketball at Division I schools. The NCAA then has rigid rules on what college players can receive in return for playing their sports: not only can they not get monetary gifts from the school but the ban extends to cover the most trivial of gifts. From an economic standpoint, this strikes me as a modern version of indentured servitude. If you are a superb basketball or football player, you have to play for a college of your choice (that is the NCAA's concession to free choice) for nothing, before you can play professional football or basketball. The colleges and the networks make millions but the players (who are the stars of the system) get scholarships, worth a few thousands and risk career ending injuries while doing so.
As I watch the "amateur" label debated in college athletics, I am reminded of similar debates that occurred in tennis and the Olympics. For decades, we kept our best tennis players out of the big tournaments in the interests of maintaining the illusion that these tournaments were just for amateurs; I can only imagine how many Wimbledons that Rod Laver would have won, if he had been allowed to play in his prime. For decades, the Olympics forced great sprinters and athletes to pick between being champions and making a living, before bowing to the reality that you cannot win the 100M by practicing just on weekends.
Don't get me wrong. I love college sports, but I think it is time to strip the hypocrisy out. My proposal is that we create two classes of college athletes: The first would be "student athletes", who get scholarships, but focus on taking classes (regular classes, not Mickey Mouse ones) like other students and get college degrees. Some of them may find that they are good enough to become professional, but most of them will play college sports and then move on to bigger and better things in life. The second would be "semi-pro" athletes, who will be allowed to earn an income (we can put caps on the income and restrict what colleges can pay, if need be) while they played and earn money from advertisements and sponsorships. They would be required to be visible on campuses and allowed to take classes, if they choose to. Colleges would also be required to set aside a portion of their revenues to cover the health and personal costs incurred by college athletes. I think I would still enjoy watching UCLA play basketball... while knowing that the Bruins on the court are making a reasonable living while playing the game.
Thursday, 11 November 2010
The secret to investment success: Self Awareness?
I know that there are many who claim to have found the secret ingredient to investment success, though few actually deliver. However, I want to present an unconventional ingredient that I think most academics and practitioners miss when they talk about investment strategies: your personal make-up as an individual.
In one of my books, Investment Philosophies, I start with a puzzle. There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.
My explanation for the puzzle. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.
Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.
As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt idek,
Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes. In the table below, I list the investment philosophy that fits best given your time horizon and views on the market:
In one of my books, Investment Philosophies, I start with a puzzle. There are many different investment philosophies out there and they range the spectrum both in the tools they use (charts for some, fundamental analysis for others..) and their views on markets (markets learn too slowly, markets over react). In fact, some of these philosophies directly contradict others. But there are two puzzles. The first is that there are a few investors within each philosophy who have succeeded in using that philosophy to great effect over their lifetimes: there have been successful technical analysis, value investors, growth investors and market timers over the last few decades. The second is that within each philosophy, success seems to be elusive for most of those who try to imitate the Warren Buffets and Peter Lynchs of the world.
My explanation for the puzzle. Every investment philosophy works but only for some investors and not all of the time, even for them. Each investment philosophy requires a perfect storm to succeed: not only do the times and circumstances have to be right for the philosophy but the investors using it have to be psychologically attuned to the philosophy.
Consider, for instance, the investment philosophy that many argue is the best (or at least the most virtuous) investment philosophy for all investors. Good investors, they claim, invest long term in companies that are fundamentally under valued, usually in the face of market selling. Here is the problem. The strategy sounds good and makes money on paper but requires three ingredients from investors for success: a long time horizon, a strong stomach and a willingness to go against the grain. If you are an impatient investor, who has a worry gene and care about peer pressure, adopting this strategy will be a recipe for disaster. Not only will you end up abandon your investments well before they pay off, you will make yourself miserable (and physically sick) in the meantime. For this investor, a short term momentum strategy makes a lot more sense.
As you think about what investment philosophy is right for you, here are some things about yourself that you may want to think about:
1. Are you a patient or impatient person?
2. How do you respond to peer pressure?
3. Are you a "worrier"?
4. Are you a details person or a big picture person?
A little self introspection will pay off much more than investing your money in another "get rich quickly" book or investnebt idek,
Ultimately, what I am arguing is that there is no one best investment philosophy that works for all investors. The right investment philosophy for you will depend upon your time horizon as an individual and what you believe about how markets make mistakes. In the table below, I list the investment philosophy that fits best given your time horizon and views on the market:
Momentum | Contrarian | Opportunisitic | |
Short term (days to a few weeks) | · Technical momentum indicators – Buy stocks based upon trend lines and high trading volume. · Information trading: Buying after positive news (earnings and dividend announcements, acquisition announcements) | · Technical contrarian indicators – mutual fund holdings, short interest. These can be for individual stocks or for overall market. | · Pure arbitrage in derivatives and fixed income markets. · Tehnical demand indicators – Patterns in prices such as head and shoulders. |
Medium term (few months to a couple of years) | · Relative strength: Buy stocks that have gone up in the last few months. · Information trading: Buy small cap stocks with substantial insider buying. | · Market timing, based upon normal PE or normal range of interest rates. · Information trading: Buying after bad news (buying a week after bad earnings reports and holding for a few months) | · Near arbitrage opportunities: Buying discounted closed end funds · Speculative arbitrage opportunities: Buying paired stocks and merger arbitrage. |
Long Term (several years) | · Passive growth investing: Buying stocks where growth trades at a reasonable price (PEG ratios). | · Passive value investing: Buy stocks with low PE, PBV or PS ratios. · Contrarian value investing: Buying losers or stocks with lots of bad news. | · Active growth investing: Take stakes in small, growth companies (private equity and venture capital investing) · Activist value investing: Buy stocks in poorly managed companies and push for change. |
Thursday, 4 November 2010
QE2 or the Titanic?
The big news of the moment (other than the election) is the Fed's decision to inject $ 600 billion into the economy, as a monetary stimulus to get the US out of a recession. Here is Bernanke's rationale:
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html
Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash more borrowing by consumers and companies. I see four problems:
1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?
2. Existing leverage: The average US household already has too much debt, some of it reflecting a hang over from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more? It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?
3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counter productive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?
4. Currency devaluation: Related to inflation fears is the effect on the US dollar, which has been under selling pressure for a while. A dollar devaluation will also make imported goods more expensive in the US, and given the trade deficit, that has to feed into price increases in the future.
Having listed these concerns, I must confess I am not a macro economist (and have no desire to be part of that crew). The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs. At least, I hope so...
I don't know about you, but I am starting to wonder about these multiple stimuli. Using the analogy of the emergency room, those electric paddles used to shock a faltering heart back into a rhythm are a godsend for someone with cardiac arrhythmia, but I also know that they sometimes do not work. That is when the cardiac surgeon is called in for more radical remedies or worse. To stimulate the US economy, we tried QE1 and it did not work, we tried FS1 (Fiscal Stimulus 1) and it did not work either. Now we are trying QE2 and if we listen to Paul Krugman (who must be having seances with Keynes every night), we should try mega FS2 next...Perhaps, it is time to accept the reality that there is something fundamentally wrong with the economy that stimuli will not fix. And perhaps, it is time to call in the surgeons! (Let's not even think about the other alternative)
And for those of you who may be wondering about the title of this post, here is the original QE2.
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html
Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash more borrowing by consumers and companies. I see four problems:
1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?
2. Existing leverage: The average US household already has too much debt, some of it reflecting a hang over from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more? It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?
3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counter productive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?
4. Currency devaluation: Related to inflation fears is the effect on the US dollar, which has been under selling pressure for a while. A dollar devaluation will also make imported goods more expensive in the US, and given the trade deficit, that has to feed into price increases in the future.
Having listed these concerns, I must confess I am not a macro economist (and have no desire to be part of that crew). The Fed presumably has access to "experts", who have thought through all of these issues and decided that the benefits overwhelm the costs. At least, I hope so...
I don't know about you, but I am starting to wonder about these multiple stimuli. Using the analogy of the emergency room, those electric paddles used to shock a faltering heart back into a rhythm are a godsend for someone with cardiac arrhythmia, but I also know that they sometimes do not work. That is when the cardiac surgeon is called in for more radical remedies or worse. To stimulate the US economy, we tried QE1 and it did not work, we tried FS1 (Fiscal Stimulus 1) and it did not work either. Now we are trying QE2 and if we listen to Paul Krugman (who must be having seances with Keynes every night), we should try mega FS2 next...Perhaps, it is time to accept the reality that there is something fundamentally wrong with the economy that stimuli will not fix. And perhaps, it is time to call in the surgeons! (Let's not even think about the other alternative)
And for those of you who may be wondering about the title of this post, here is the original QE2.
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