May 2009


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Continuing from my last post where I had left the juicy part of the book for this post, here I go :

The last topic contains ideas which I find fascinating. Markets are complex adaptive systems and one can understand it better if you have systems thinking. Peter Senge’s Book “The Fifth discipline” had a great impact on my way of thinking and each essay in the last part of the book is a suggestion towards developing such a kind of thinking.

The author points out to the need for diversity in thinking. Reading about how stats is used in baseball to improve a team’s performance can teach you a lot than trying to look for cases in your own domain. A healthy discussion with a ecologist can give you more insights about speculation in financial markets than trying to look at indicators from the same field. Google’s search engine and the way it used eigen value decomposition can provide you with a far more insight in to the usual factor analysis of stock returns. Research evidence from study of ants, bee-hives can give clues about how markets aggregate information.

Decision markets, and readings like “Wisdom of Crowds”, ” Wikinomics” can give you insight in to taking positions on a stock or a derivative.
Study of fractals is more meaningful than studying and working on the same old academic finance theories which are based on normal and log normal distributions. Power laws and the ways Power laws are used in fields like economics, psephology and like can help one understand markets better.

The entire point of the essays under this section is to urge you to keep your mind active and open to things happening in fields which might not seem related at the outset. Markets as a system can be understood better by applying ideas and thoughts from other fields.

Take any branch of finance in today’s date..It is crying for contributions from other fields..It is being flooded by sociologists, ecologists , psychologists, who know that finance as a discipline can grow only by fusion of ideas from various fields. Case in point , Mandelbrot’s fractal finance. Finance literature has virtually nothing on fractal finance as compared to the other kinds of literature. I had a chance meeting with the Mr.Barone Adesi , the person behind closed form solution for american option. I asked him whether he would consider research in fractal finance a viable option for a budding researcher. He said, he had himself worked on it for 2 years and was hopeful that research will pick up in this area.

I remember another faculty giving an analogy of ants in research literature. If you place something that attracts ants and you see to it that there are only 2 possible ways, inevitable one of the ways gets used by ants and the whole path is jam packed, even though an alternate path is available. This is similar to academic literature where it is only by getting references and citations from similar research initiatives , can one publish papers. Coming back to the analogy of Ants, once in a while , a few ants move from the pack and explore new paths and that is how ants as a community survive. Finance has reached a stage where it needs such diverse thinking and one can only hope a few people from academia or a few practitioners will actively stray from the usual path and help us answer some of our questions on

  • How do markets aggregate information ?
  • What does aggregation mean from market efficiency ?
  • Concept of risk remains incomplete
  • We don’t know how our brains work ?…………………….and many more such questions that need to be looked at.

    ImageThis book reminds me of a set of essays I read a few years ago, “Essays on Derivatives” by Don Chance. Each of the essays revolved around a simple but powerful idea. I get the same feeling after reading this book.This book provides a lot of food for thought. If you want to think on the areas where finance concepts have to be worked on, read this book..Out of 30 ideas, I am certain that atleast a few will interest you.

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This book contains about 30 essays , meaning 30 ideas which can be read, ruminated and possibly applied in real life situations wherever they are applicable. Though the book is about finance, it draws considerable amount of research evidence from Biology, Math, Sociology,etc . At a 10,000 ft view , actually each discipline is nothing but an effort to understand the world using a set of constructs.

I would term Finance as a soft science rather than hard science where the discipline needs to be understood from various eyes . For a number cruncher , it becomes all the more important to realize that numbers,statistics is after all ONLY one part of the story in markets. One must consider market as a complex adaptive animal where numbers is ONLY one part of understanding. The more the mental models one has, the better one is equipped to understand what’s going on.

I will try to summarize the key idea from each of the 30 essays from the book.

Part I

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  1. Process is more important than Outcome in Investing
    Always consider success as a lucky realization unless you backtest it. Just because you make money using some trading rule does not mean that you are going to make it again. There is an undoubtedly a strong relation between good process used to make a decision and a good outcome. Think about it, this applies not only to investing but also to most of the things we do in life. Lets assume that you think that C# is the best language to create something that is needed, but somehow your skills are rusty and you would rather do it with VBA and build the same screens etc. Well, it might be probably good for short term, but can anyone use the tool apart from you? Is it Scalable ? Does it have a wow! element ? Is it extensible ?

  2. Constant see-saw between Investing considered as Business or Profession
    This is the same point which Daniel Kahneman makes about the scale struggle. Money managers consider Investing as a business and work for the immediate goals and immediate returns (quarterly/yearly) but Business operates on a longer scale. I think instead of thinking of it as a Business or Profession, it is best if one can think of it as a Business and Profession. There will always be some assets which can be shorted at a professional scale and always some assets which can be longed at a business scale.
  3. Babe Ruth Effect
    Well, this one is pretty well known. Focusing on frequencies and not on the Expected value can kill a risk manager. The same idea as Taleb’s Pi Lambda. In Mediocristan, Frequencies are important because payoff is pretty much symmetrical. But in Extremistan, it is important to understand the payoffs are not symmetrical. Infact they are very skewed and following frequentist approach is equivalent to being a sucker.
  4. Proper Categorization is the Key (Context based)
    Most often than not, we categorize things and do not check the stationarity of the categories. My best ever read on categorization is an essay by Clay Shirky (Ontology is Overrated). Categorization as a subject has always fascinated me. In this book however the author says theories based on static categorization are not good. Well, we all know it, but how many of us actually keep that in mind when we go about theorizing, categorizing world events.
  5. Learn to translate uncertainty to Probability.

    Degrees of Disbelief, Propensities and Frequencies are three ways to get to probability . Academic world is orgasmic about Frequentist world.Successful traders love propensities and uninformed trades live in the world of degrees of disbelief. For a trader who wants to trade by numbers, it is very important that he follows all the three ways depending on the context. For a plain vanilla options, frequentist is not a bad path to take. Well, you can rise over the usual theories known , do your own analysis on whether to follow mixture models, poisson+ gamma , whatever. However propensity based path needs to be taken too based on the context

  6. There is a Hot Hand in Investing, if not in baseball

    Long streaks of success typically indicate luck imposed on great skill

  7. Equity Premium Puzzle
    Loss aversion and Myopia can explain the equity premium puzzle. Somehow I felt that is is the same time scale difference that is being brought out by the author

    Part II : Psychology of Investing

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  8. Link between Stress and Suboptimal portfolio Management

    Essay beats the same point. Money managers operate on Shortening horizons, leading to stress to leading to suboptimal portfolio performance

  9. Persuasion

    Robert Caldini’s 30 year work is wonderfully summarized in this essay. The construct that there are 6 tendencies that spur a behavioral change : Reciprocation, Consistency , Social Validation, Looking, Authority and Scarcity . Each of these 6 tendencies are important when you need to think about the trading behavior change that can be observed in the market or trading rooms

  10. Emotion and Intuition in Decision making
  11. Guppy Love : Role of Imitation in Markets
    Asymmetric information, Agency costs and Preference for conformity are three things which force traders to confirm. But this also leads to Herding.
  12. Beware of Behavioral Finance

    This chapter was like a breath of fresh air in this book. Behavioral Finance follows the reasoning, Individuals are irrational and an aggregation of irrational individuals must lead to an irrational market. However the essay says that ” Markets can still be rational when investors are individually irrational”. Meaning there is a law of large numbers at play. The very fact that players operate at different time scales, investment styles and investment approaches means that diversity will always ensure collective rationality.. Which means whenever there are imbalances the market corrects itself. Well, Do I agree with this view ? I don’t think I am knowledgeable enough to form a view. But as such as a basic premise,I do believe in collective rationality and individual irrationality. But again, it is just a belief with no evidence to back it up

  13. Essay on Keynes Expectation theory

    Comparison of Markets to “Beauty Contest” and “El Farol Bar”. The idea that is conveyed in this essay is about deductive Vs inductive reasoning. Inductive is how we operate and it brings itself with a variety of bias. Deductive is how economics tries to operate , applying general principles to specific. In the case of markets, it ought to have been deductive but looking at market players, it appears inductive.This debate of deductive and inductive reasoning is brought out clearly.

    Part III: Innovation and Competitive Strategy
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    I had a very strong tendency to skip over these essays for the simple reason that I have grown indifferent to the words strategy, competition, innovation etc. These are words, I remember , back in B school days, I was so fond of. It seemed as though using these words and thinking on these lines was leading to productive thinking. Over a period of time, I have realized that these are just fillers in conversations when you don’t have clear thinking. In fact all the buzz words that I learnt at B school, I have consciously tried to avoid over the past few years. These words look good in case studies and HBR articles … that’s all there is to it. If you have to do anything productive, I think it is better to ignore these words and think in simple terms.

    With this kind of strong aversion towards such words, I was in no mood to go over these essays on strategy. But then I gave in, thinking that I might get at least some simple & meaningful thoughts from the next 7 essays. What did I find ?

  14. blah-blah-blah-blah
  15. blah-blah-blah-blah
  16. blah-blah-blah-blah
  17. blah-blah-blah-blah
  18. blah-blah-blah-blah
  19. blah-blah-blah-blah
  20. blah-blah-blah-blah
  21. blah-blah-blah-blah

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    As expected the entire part on strategy was like reading some old Bschool case..It bored me to death!! The only thing that I found was somewhat educative was about fitness landscapes. Again you can term it as old wine in new bottle. The other possible idea which deserves a mention is the analogy of chess players and traders

    — Don’t look too far ahead

    — Develop options and continuously revise them based on the changing conditions

    — Know your competition

    — Seek Small advantages

    Again the above points are cliched, but the essay is a little better as it brings about nice chess analogies using these points.

    Part IV: Complexity Theory

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    This part of the book rocks!


    Will summarize the last part of the book in my next post

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It is almost 2 months since I read a book. Finally after the bhag daud in Mumbai , managed to find time to peacefully sit and read a book. Thanks to Sanjiv Sir’s awesome book collection, managed to get my hands on “SWAY”. The first time I came across a mention about this book was when a trader recounted his experience about a Variance swap trade and related his behavior to that explained in the book “SWAY”.

Well, tons of books have been written after the explosive growth of behavioral economics. “Does this book offer anything new to me”, was my feeling when I began reading.

Loss aversion : KLM disaster mentioned is a case of loss aversion where dangerous decisions are made to avert losses !! . The possibility of a potential loss makes you avoid that loss at any cost…Sometimes it is too costly as it the case with KLM airline where the pilot had a potential loss of reputation at stake that lead to one of the most ghastly flight accidents in the airline history.

Commitment Sway : $1 auction at Harvard is an example of commitment where a strange type of auction brings about the irrational tendencies in perfectly rational people. This is similar to, well, I have already committed so much of time and effort towards this..Let me go about it doing the same thing….It happens in startups, relationships, companies, everywhere…Sometimes, it is difficult to say QUIT, even though it is an rational thing to do. Reminds me of “DIP” from Seth Godin…Its a wonderful book that makes your mind flexible and forces to take some tough decisions.

Value attribution : We assign value to things unknowingly and we make decisions based on the value attribution with out rechecking our assumptions that lead to ascribing the value.

Diagnosis Error :
The take away from this is : When we are in a position to make a diagnosis, we all become overly confident in our predictive abilities and overly optimistic about the future. For a number cruncher, this is probably the most important thing to keep in mind. If you see some pattern, back test it rigorously, have a healthy skepticism for whatever you are seeing.

Fair Value
Fair value is something most of the traders think day in day out. Is it priced at fair value ? Umpteen examples in this book show that pure objectivist fair value assessment is not the norm of the day. One of the interesting examples quoted is that of the popular TV show, “Who wants to be a millionaire”. Audience poll is something which the contestant uses when he/she doesn’t know the answer thinking that the audience will help him/her out. In some specific countries it has been found that audience deliberately misleads the person who is playing!! Fair value reasoning is used to explain this behavior

Compensation and Cocaine:
There is an interesting chapter on influence on incentives. Performance incentives and its effect on productivity is always something that is paradoxical to me. If you give me a differential equation and ask it to solve, i might work on it for hours and solve it to just to get kicked about the fact that I am able to crack it. However if you attach $X to it and ask me to solve, somehow I start reacting to the same situation differently. I become less motivated. I have read at innumerable places about a similar behavior , though in different contexts. An activity which is done to derive pure pleasure out of it, seems different where monetary incentives are attached to it. I remember a friend of mine who loved writing and he decided to join a media firm . Soon enough, he was demotivated and left the media firm. By attaching a $X to his writing, probably he felt less motivated to write any more and was forced to think about deadlines!.

This type of issue always makes me think of wallstreet people, traders etc who , atleast as the media portrays are motivated by monetary incentives. So, “Is beating the market that gives them thrill” OR the result of beating the market,money, is what drives them is something I do not know. At least the world portrays that year end bonus is all traders look for…If that is the case, they are not there to beat the market for the sake for it, but purely money driven. Incentive structure, especially monetary is wild animal. For some people, it motivates to do better, For some people , it actually demotivates. To this day, I have never really understood the reason.

Coming back to the contents of this chapter, the authors say that there are 2 distinct centers in our brain. One area is related to addictive substances like monetary incentives, cocaine, drugs and other area which is altruistically inclined. Book quotes research evidence that the pleasure center hijacks altruistic center and changes the behavior of the person completely. Well, I know one friend of mine who is working towards building a great firm and ultimate wants to make tons of money. However when asked the reason for doing the same, he says the drive is purely based out of altruistic reasons. The evidence in the book at least says that it is generally the addictive center which will have a major say in how one goes about in life. So, whenever you hear the words, ” I want to make money so that I can donate them later “, you got to read this chapter from the book to convince yourself that it is actually the pleasure center that has hijacked the person’s mind and altruistic center is somewhere in the back ground.

Subroto Bagchi, in his book, High performance entrepreneur , also echoes the same sentiment. An entrepreneur has to be financially driven and he invokes an Indian mythology argument saying that Money is Goddess Laxmi and she runs from you at the slightest instance of disrespect or apathy. Well, if you pitch this argument to any Indian, mostly they are going to buy it 🙂 .Anyways the point is I guess, one needs to be clear on these 2 aspects and make decisions accordingly in various situations.

ImageBook is extremely light read and will make you ponder atleast a few things , considering that there are tons of examples cited. For a time strapped reader, the synopsis at the end of the book should more than suffice. I have “Nudge” , a book echoing similar sentiments is far more engrossing.Will read it someday.