Falkenblog

I recently made a presentation of my book, The Missing Risk Premium, and thought it was concise, so I'm sharing it here.

• Within equities:
• Firm leverage
• Firm profitability
• CAPM beta
• Total Volatility
• Residual Volatility
• Financial Distress/Default metrics and equities
• Penny stocks vs. regular stocks
• IPOs vs regular stock
• Country returns in developed countries
• Country returns in emerging markets
• Analyst disagreement across stocks
• High vs. low trading volume
• R rated movies vs. G rated movies
• Volatility/future equity Index returns  over time
• Overnight vs. Intraday stock returns
• Bond credit: Distress, Junk, and  BBB-A rated Bonds
• Bond duration: post 2 years
• Out-of-the-money options vs. at-the-money options
• S and C corps  vs. equity indexes
• Senior vs. Subordinated
• Reinsurance: rebalanced vs. peak peril
• Converts: low and high moneyness
• Merger Arbitrage: stock-financed vs. cash-financed
• Lotto vs. ‘quick pick’ lotteries
• 50-1 horses vs. 3-1 horses
• Mutual funds
• Hedge Funds
• Commodity Trading Advisors (CTAs)
• Currencies
• Futures
• Real Estate

• Short end of yield curve
• BBB-Treasury credit spread
• Top-line equity return over libo

• Overconfidence
• Information costs lower about risky firms
• High returns have high risk, ergo risk implies higher return fallacy
• Some are risk loving
• Some people are positive skew loving
• Alpha discovery
• Easier sell to clients (amenable to stories)
• Payoffs to fund managers
• Bounded rationality  (think SML is positively sloping)
• Agency problem (exploit option with fund source)
• Those buying stocks think stocks will rise, in which case higher beta is better

• Tradition (60-40 stock/equity ratio is a binding constraint)
• Irrationality (others don’t notice SML flat/negative)
• Relative risk (my favorite, other consistent data below)
• Easterlin Paradox suggests happiness is relative
• No one sells low risk, lower-than-average return stocks, because in a relative risk world, one only takes risk if the return is above average
• home bias because you want to outcompete your peers, not strangers
• Relative orientation evolutionarily robust compared to a Constant Relative Risk Aversion utility (which would be a strange coincidence)
• Glucocorticoid levels such as cortisol related to status, not wealth
• Imitation generally dominates figuring things out oneself (eg, fire, calculus), leading to an other-person directed brain
• fMRI identifies neural mechanisms for empathy, social information
• Status is a human universal, greed is not
• Reverse dominance hierarchies in humans common (ie, status more important than wealth)
• Politics about redistribution more than efficiency

• 40% of all men reproduce, where 80% of women do. 
• Men have out-of-the-money option, need to take risk
• Why not take infinite risk? Moderation in all things.
• Life is a complex, nonlinear, dynamic game where every parameter has a local maximum. Radiation, vitamin A, oxygen, tolerance,  risk taking, can all be too much or too little.

Many assume that pre-modern society was communistic, like hunter gatherers, and these roots give us a socialist intuition. Larry Arnhart argues this simply isn't true, that hunter-gatherer societies share big game meat, but most everything else is shared communistically only within the nuclear family, other things are more quid-pro-quo.

 This comes up a lot, as Emmanuel Todd writes interesting books about European history, as in his 1990 L’invention de l’Europe. He makes the bold claim that political ideology is the result of three things: family structure, literacy, and godlessness. In the modern age with universal literacy and godlessness, political ideologies are mainly projections of a people’s unconscious premodern family values.

 As my politics are opposite of my two siblings, my family structure clearly explains little, but perhaps that's just because I'm truly exceptional.

Ever since Freakonomics and Kahneman's Nobel prize, people have been writing articles about the radical new idea that people are not lightning-quick calculators complicated algorithms as economists always thought, but instead, real people! True enough, but it's useful to understand what rational really means, and why it's used so much by economists. Here's Milton Friedman (22:15ish) noting why it's basically about predicting what people do, on average, nothing more:



Also interesting, a fetching young Laura Tyson asks a question around 34:45. I think she's aged well too (Keynesians may be wrong, but they can be cute)

There's an interesting paper on High Frequency Trading (HFT) by Budish, Cramton, and Shim from the U of Chicago. They set up an interesting model, but then propose at the end that batching eliminates the HFT arms race, both because it reduces the value of tiny speed advantages and because it transforms competition on speed into competition on price. I think that solution is interesting, but would prefer the following

1. add a 20ish millisecond randomizer to any incoming order (ie, a lag of anywhere from 0 to 20 milliseconds). Thus, if you know you are getting randomized, the marginal value of 1 millisecond is much smaller to the innovator, your place in the queue is noisy. 
2. make a rule that those who receive fees (liquidity providers) must have such orders exist for at least 1 second. That would get rid of a lot of flash quotes that are trying to be too clever and simply clog the bandwidth.

In any case, we have several different exchanges, and so if there's a simple way to increase welfare, an exchange that adds any such rule would generate more traffic, and ultimately, imitation. Yet, that's how paying for liquidity provision (passive quotes) originated, as well as a bunch of other tactics. One thinks they are annoying features created in a smoke-filled room, but instead they were simply the result of giving market participants what they want. A retail trader can always opt-out by simply trading at the Volume-Weighted-Average Price (VWAP), because that gives you the average daily price that averages out all these shenanigans, so I really don't have any sympathy for those who are bothered by it: if you don't like the intraday game, don't play it!

But, I was intrigued by the idea of batch auctions, because I've heard people who think discrete auctions are better than continuous ones. I think they are not very good, and a simple example is an extreme of this, one can look at the performance of closing vs. opening prices. One is at the end of continuous trading, one where there's no trading. What happens?

Well, I looked at over 1000 stocks, from 2000 to today.  I excluded really small, low-priced stocks.   The Open-Open returns have slightly higher volatility (2% higher), but more importantly, there's a lot more 'mean reversion'.  The graph below shows the future returns(O-O or C-C), sorted each day into deciles by the immediate prior return (O-O or C-C, respectively), then averaged over all those days.

Pundits, websites, and news programs had very predictable opinions on the guilt of Zimmerman based on their view about Keynesian multipliers.  Those that favor more redistribution, more governmental spending and regulation overwhelmingly sided with Trayvon Martin, the deceased African-American. Clearly that's not a coincidence, but reflects something deeper, mainly a peculiar groupishness.

Now, if basically prejudices drive reason as opposed to vice versa: what's the most basic belief there?  It's not obvious our beliefs on fiscal policy and criminal justice would be almost perfectly correlated.  Jonathan Haidt wrote a great book on moral confabulations, but I don't think his 6 foundations of political thought help here.  For example, both think their side is 'fair', just for different reasons.  Instead, I think it's people choosing in-groups vs. outgroups, the basic building block of multilevel selection theory outline by David Sloan Wilson.  Thus Harvard elites and  don't mind quotas because,as Harvard grads, they will get the good jobs anyway.  Those in elite positions don't mind quotas, get the support of quota recipients, and can portray themselves as progressive; those in the middle look like selfish bigots, and they lose.

Ultimately, via the logic of Hotelling's median voter theory, there are two teams, and while they are somewhat inconsistent in their beliefs (free choice in abortions, but not employment or insurance)  these beliefs form the most basic coarsening of a set of two self-interested groups.  Everyone likes their team, and want power at the expense of those on the other side.  It's Lenin's Who, Whom? 

Marx's historical dialectic class struggle was profoundly wrong: it has never been simply poor vs. rich, but rather complex coalitions that interweave, because rich need the numbers of the poor and the poor need the capital and skill of the rich.  Think about academic elites and the really poor: they are both heavily Democratic. It clearly isn't just rich vs. poor.

Of course, this also means most debates about the multiplier are  pointless because if I can predict whether you think the multiplier is large based on your beliefs about Zimmerman's guilt, the real issue has not much to do with econometrics.  If you are doing objective work on multipliers, remember no one expects details to be dispositive, the narrative will drive what facts are seen as irrelevant or essential.  

When Rational Expectations was developed in the 1960s most people thought it was a classic academic result.  Certainly mutual fund managers chuckled at the thought a monkey could outperform a skilled professional.  Further, everyone had a stupid relative, neighbor,  or co-worker, that proved people were not rational. Meanwhile, the Capital Asset Pricing Model (ie, Beta), meanwhile, was accepted as true even before data suggested it was.

Yet, we now have almost 100 years of data showing mutual fund managers do not outperform naive benchmarks (Cowles foundation (1932), Malkiel's Random Walk Down Wall Street (1973)), making the signature prediction of rational expectations surprising and true, a sign of a great theory.  Samuelson’s (1965) application of the law of iterated expectations to explain why Bachelier (1900) notices that securities prices look like a random walk, made for both elegant theory and voluminous evidence. The efficient markets theory reached its current plateau in 1970 with Fama's articulation of what efficient markets mean, but never has it been generally accepted by practitioners or non-economists, and there have always been many economists looking at exceptions to this rule.

The latest refutation of this plank of economics sounds very similar to a middle-aged economist reading this stuff:

Psychologists ... say that markets are not immune from human irrationality, whether that irrationality is due to optimism, fear, greed, or other forces.... "There's this tug-of-war between economics and psychology, and in this round, psychology wins," says Colin Camerer, the Robert Kirby Professor of Behavioral Economics at the California Institute of Technology...

What did they show? That people basically make inconsistent bets when presented with subsets vs. supersets, for example, the odds that Hillary Clinton (Democrat) will win the Presidency is less than the probability a Democrat will win the Presidency, though in aggregate surveys this doesn't always hold.

It's been long known that people over-estimate specifics based on things like the availability heuristic, as when people more easily think an introverted woman is a librarian than an accountant because it fits with what one can think about as an archetype, and this has been discussed since the 1970s (see Kahneman, Tversky and Slovic's Heuristics and Biases). This is patently illogical, and spawned the behavioralist revolution, where we have about 100 such biases.

Yet, it's one thing to say people are inconsistent, another to say liquid markets are. While a random survey of retail investors might have the equity premium at something silly like 10% or the odds of a US default at 5%, that doesn't mean derivatives are priced that way, because knowledgeable people with capital tend to arbitrage these beliefs out of the market. For example, Snowberg and Wolfers showed that horse races are illogical looking at millions of races, and this has been known since 1949 (note: the favorite has the highest expected returns). Yet, to the extent such prices reflect this inconsistency, it isn't large enough to make large amounts of money. Does this translate to anything about the general market, or tradable stocks like those in the Wilshire 3000? Almost always, no.

These findings strike me a bit like this finding listed in a eulogy of this Harvard psychologist who sounds like just an awesome mensch, where they noted that

while teaching at the University of Virginia, he devised an experiment to study secrecy and obsessions. Enlisting college students to play card games at a table, he instructed some to play footsie under the table and tell everyone they were doing so. Others had to keep their footplay secret. One result? “The subjects who made secret contact with their partner were significantly more attracted to their partners,” Dr. Wegner told the Globe in 1994, a finding that, among other things, shed light on the allure of affairs outside relationships.

Now, that is very interesting, but it doesn't really contradict any fundamental conception of humanity, and so it goes with the behavioral finance results: neat, but not profound.

The problem with the alternatives to Rational Expectations is that they generally point out that in low-stakes environments people make logical mistakes in predictable ways, but they hardly ever explain the yield curve, the equity premium, or anything else important, but rather, the poor returns to 100-1 horses or some other curiosity. I like betting on horse longshots at the track and implicitly pay a premium for that, but it probably costs less than what I spend on beer at the track, so it's really not complicated.

Now, one might think that evolutionary biology provides a fruitful alternative, in that it tries to look at predictable expectations from the standpoint of its evolutionary success. I think that's great, and indeed, think that a relative utility function makes more sense because, among other reasons, it is more evolutionarily robust.

 David Sloan Wilson, who is well-known for showing how religion is a 'rational' adaptive solution within a multi-level selection process, has organized a special issue of the Journal of Economic and Behaviour Organisation entitled ‘Evolution as a General Theoretical Framework for Economics and Public Policy’. A lot of those articles are interesting, but none really that radical.

For example, there's the article arguing economists should use multi-level selection, as opposed to the atomistic selection implicit within abstract markets. That is, in evolutionary biology, there's a big debate about where selection occurs. Before Richard Dawkins became fixated on the specter of Christian Fundamentalists, he wrote The Selfish Gene to rebut the idea that selection occurs at the level of a species, championing the ideas of George C. Williams and John Maynard Smith. These biologists noted casual speakers would talk about 'what is good for a species', but clearly gazelles don't act as a group, but as individuals, and within individuals, as cells, and then as genes.  Dawkins argued that it's selfishness at the lowest level, the gene, ergo the title. Things have gotten rather complicated since, and it's clear selection takes place at more than one level.

For example, take the Hymenoptera order, which includes ants. There's a joke about socialism: good theory, wrong species (ie, ants not humans). For these species their genes actually assist in their goupishness, and so they willing kill themselves for the group all the time, because sisters are more related to each other than a queen is to her offspring. Thus, the selection for haplodiploidy could take place at one level--the swarm--not the gene level, and this then affects the payoffs for individuals and thus genes. Selection seems to occur at the lowest level, the genes, but also cells, the organism, and among humans, in culture. Economist Herbert Gintis has argued that societies that promote pro-social norms, as in group selection, have higher survival rates than societies that do not.

I think that's all super, and think some societies might have different intrinsic levels of individualism depending on their evolutionary environment. For example, here's nice discussion about how the Western concept of marriage outside of extended families led to a unique level of individualism, something that is rather unique to Western Civilization. In contrast, in the middle east, a lot of people marry cousins, and this breeds greater groupishness because your extended family is so obviously genetically oriented, making outsiders very clear (ie, altruism towards one's clan, indifference at best towards those outside it).

Yet, it's not clear how much these insights are really new as applied to markets and theories of the firm. Many theories apply to how oligopolies and monopolies behave, and these are quite different than what one sees for perfect competition, so the idea suggested in Wilson's Special Issue, that selection occurs at the industry, firm, or worker level, is not that revolutionary. Game theory often looks at mechanism design, and the stability of coalitions, and the conditions of various equilibrium.  I get the sense they think the only behavior economics looks at is perfect competition.  It's not, and hasn't been for 100 years.

It's generally accepted that one needs the system to obey two constraints:

1. Individuals must receive a positive return to their action
2. Individuals must be doing their best given their information and beliefs

These are sensible restrictions, so the issue is whether behavior is rational or not, from the agent's perspective. Rational expectations merely adds the requirement that any behavior should be consistent with zero abnormal profits for the simple and sensible reason that it is very difficult to generate abnormal profits in most markets. I still think that's a good bias, because it's usually true.

Russ Roberts had a podcast a couple weeks ago where he interviewed Betsy Stevenson (below) and Justin Wolfers (right), primarily about their research on the Easterlin Paradox, and it highlighted what's wrong with so many academic debates.  

To review, in 1974 USC professor Richard Easterlin found that within a given country people with higher incomes were more likely to report being happy. However, between developed countries, the average reported level of happiness did not vary much with national income per person. Similarly, although income per person rose steadily in the United States between 1946 and 1970, average reported happiness showed no long-term trend and declined between 1960 and 1970. Theoretically, utility is generally assumed to be increasing at a decreasing rate (eg, log(x)). So, if you have twice as much GDP/capita, you should be happier, but in practice it doesn't seem to work this way.

I agree with Easterlin, and the relative-status utility function is the key to my book, The Missing Risk Premium.  Utility as Stevenson-Wolfers see it is a necessary and sufficient condition for an omnipresent risk premium, that is, it exists in a symmetric if--then relation (if one exists then the other does).  Yet, the risk premium seems to show up in only three places, and is usually missing (thus, my book title), if not going the wrong way.  Furthermore, evolution favors a relative utility function as opposed to the standard absolute utility function, and the evidence for this is found in ethology, anthropology, and neurology.  Economists from Adam Smith, Karl Marx, Thorstein Veblen, and even Keynes focused on status, the societal relative position, as a motivating force in individual lives (this was before mathematical utility functions in the 1950s made the profession ignore relative position). So, this isn't just a crazy idea championed by a wacky Easterlin guy, or just wacky me.

Stevenson and Wolfers are married coauthors, and they have published at least three papers on the topic, all refuting the Easterlin finding. Wolfers states 'most economists have our view, that there is no Easterlin paradox and there probably never was.' I'm sure he is correct, that most economists share his views, but only because they always have: if economist used a relative utility function many (most) seminal models would become ambiguous, and the whole field loses much of its foundation. Interviewer Russ Roberts is the Merv Griffin of economics interviewers--agreeable to a fault--and so never presses them on what specifically causes the Easterlin crowd to see things so differently. As Stevenson is now part of the prestigious yet irrelevant Counsel of Economic Advisors and Wolfers has more affiliations than your average CFA (University of Michigan, Brookings, CAMA, CEPR, CESifo, IZA and NBER), these two represent best practices in economics. It would be useful to see what the 'best of the best' do when applying their laser-logic.

First, there's the paper that made this May's American Economics Review, Subjective Well‐Being and Income: Is There Any Evidence of Satiation? Here they document two things. First, that cross-sectionally, higher GDP/capita generates higher happiness. Strangely, they find that the income-happiness effect is at least twice as strong among richer countries, which no one thinks is true (the effect should decrease as wealth increases), and further using one set of data the effect of income on happiness is negative. The authors note, however, that this is merely because of one country, the Phillipines. Strange that 2 of the 5 observations here were significant in the direction no one argues is true.  If this was the effect of one single country, could such an explanation be responsible for the positive effect for the rich countries?  The data look disputable (one chart shows Denmark and Norway above Italy and Spain, which would be unusual).  That said, by itself it does support their assertion.

 Their second set of findings concern cross-sectional data within a country. Easterlin did not dispute this, however. Given positional goods like mates and lakefront property, relative wealth should matter. Thus, S-W spend a lot of time refuting findings that looks somewhat relevant to the Easterlin Paradox, and definitely supportive of their view, but if you are a smart economist you should understand this is irrelevant to anything but a caricature of the Easterlin idea. I don't think they are fools or consciously disingenuous, just really good at playing the game: they have convinced themselves that their academic confabulations are objective science as opposed to tendentious rhetoric.  This doesn't move the debate forward, but it does help their status in their tribe, which is what most economic research is really about and why you don't have to follow most of it.

 So, what about the original Easterlin note, that among developed countries, where people are more worried about obesity than malnutrition, as GDP/capita rises we aren't getting happier? Well, Sacks, Stevenson, and Wolfers (2013) adress this point directly, and show this chart, where happiness is on the y-axis (vertical), and log GDP normalized for country and 'waves'.  Now, 'waves' is the name for the particular set of years a specific survey tended to use identical phrasing and protocols, which usually last a handful of years, thus each such set was assigned a fixed-effect.  Here is the resulting data, and their 'effect' in the line just in case it isn't obvious to you.


When an economist tells you a symmetric ovoid contains a highly significant trend via the power of statistics, don't believe them: real effects pass the ocular test of statistical significance (ie, it should look like a pattern).  Here's another view of the data we are interested in--change in log(GDP)/capita over time within a country--versus change in happiness, using a variety of surveys:


Again, for each its happiness on the y-axis, income on the x-axis.  S-S-W add little lines trying to show a pattern that they are sure is there.

Now, two can play this game, as from 2010 Easterlin and co-authors have data with similar blobs, but they draw downward-sloping lines over them.


I think it's best to say, no relation, and to stop drawing lines on blobs.

In any case, the biggest problem with the Sacks, Stevenson and Wolfers analysis is that they estimate a short-term relationship between life satisfaction and GDP, rather than the long-term relationship. Surely over an economic cycle, say between 2007 and 2009, or 1999 and 2002, income is correlated with general anxiety in the predictable way. Only over decades does the null effect of income on happiness arise, and this is basically taken out via 'wave-fixed-effects', which are basically time-dummies for 5-year groupings.

While I think people who aren't fighting for basic necessities are focused primarily on status and the things it can buy, I don't think this implies we should be indifferent to growth.  That would be the naturalistic fallacy, that 'is' implies 'ought.' We should aspire higher than envy, which paradoxically seems to elevate greed, but really just forces us to be grateful for things like the internet, strawberries in winter, and five-blade razors that we take for granted once everyone has them. I note many writers I otherwise admire, usually libertarian leaning, are quite averse to the Easterlin conclusion, thinking it will lead us to adopt a luddite policies because growth would not matter in such a world (see Ron Bailey here, or Tim Worstall there).

The key is that while I admit that my relatively impoverished grandfather was probably as happy as I am, I'm also very glad I live now: growth is good in spite of my envious homunculus.  Further, as productivity growth is the natural consequence of free minds and markets, flattening growth means not merely focusing on 'more important things' but rather squelching freedom, and liberty is more important than equality because it's feasible while allowing a great deal of the latter.  In contrast, true equality is only possible via force because people are not equal in effort or ability.  I mean, how would one prevent Larry Ellison or LeBron James from being richer than everyone else? The only way would be to destroy new companies or merit-based systems, why the worst rise to the top in hierarchies based on non-pnl signals, with examples from smarmy politicians, clueless executives in large regulated corporations, and of course genocidal socialists.

150 years ago, Gettysburg was fought.  Here is War Nerd on the battle:

You know how many civilians were killed in the whole battle of Gettysburg? One. I dare anybody from any other country anywhere, any time, to find me a battle with over 50,000 military casualties—and one civvies died. One! It’s incredible. People don’t realize how amazing that is. Those were supermen, there’s no other explanation. You read their letters and they write in complete sentences, they even have great handwriting, even the paragraphs work.