The Importance of Being Honest

This is a great article by E. Derman and Paul Wilmott on  how we should be careful with our models. Here are their suggestions at the end,

• I will remember that I didn't make the world and that it doesn't satisfy my equations.
• Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
• I will never sacrifice reality for elegance without explaining why I have done so. Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
• I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension. 

It is so easy to get lost in the mathematics of models that we often see papers completely out of touch with reality...

Behavioral FInance

Wow. Summer is busy even after classes are over! I thought I'd have more time to post but, as usual, we can't get what we want... Anyway, this is an interesting article that appeared in the FT about a hedge fund that uses behavioral finance techniques to invest.

Personally, I believe that behavioral finance brings essential insights on how financial models should strive to incorporate the idiosyncracies of human behavior rather than to take the easy way out and assume that investors are perfectly rational. However, up to now at least, I think that behavioral finance is still at a point in which is more like a collection of results challenging the current paradigm ("mainstream" finance) but still not able to come up with a good alternative theory. I'm not sure it ever will given how "strange" human beings can be whenever money is involved (or generally).

Altogether the article is very interesting and contains a useful introduction to behavioral finance. The trading strategy looks interesting too! Here is the beginning:

Before you even started reading this article, it had already been electronically scanned and its language examined by dozens of computers at hedge funds and investment banks.

At MarketPsy Capital in Santa Monica, California, remote servers will have rated how positive or negative it is on the economy and checked for emotional content on thousands of companies. Finding nothing useful, the computers will then move on.

Equity Premium Puzzle

Today I received a very interesting email from one of my MBA students. Here is what he wrote:

"Professor Saffi,

I noted an article of interest on one of the financial blogs I read, titled "Revisiting the Equity Premium" (http://blogs.reuters.com/felix-salmon/2010/05/20/revisiting-the-equity-premium/). The blogger advances three main points in the article;
1) most managers are not sure why they use an equity premium of 5%-8%

2) That two noted researchers indicate the premium is really 0%-2%
http://alephblog.com/2009/07/15/the-equity-premium-is-no-longer-a-puzzle/
http://falkenblog.blogspot.com/2009/07/is-equity-risk-premium-actually-zero.html

3) That we assume that equities MUST yield more than treasuries based on efficient market hypotheses, however, rather than must, we should be using the word HOPE and recognize the incentives in the system and that the past will not reflect the future.

Please let me know what you think."

Here is my reply:

At the end of the day, the magnitude of the risk premium depends on the risk aversion of investors and the future cash-flows of firms that capture productivity gains (i.e. their average returns). The idea behind using past data is exactly to try to have an estimate of its current value, which can also fluctuate over time. Is it possible that investors have been greatly exaggerating this future estimated performance? Yes, it could. In my humble opinion, this is also related to the Malthusian theory that mankind won’t be able to keep raising food productivity. People have been saying that for 210 years and we’re still going strong

To be honest, one reason why managers don't why they use 5-8% is because most have never seriously studied its determinants. This guy here probably doesn't as well:

Schrager then continues her argument with this:

“Equities are inherently riskier than Treasuries. Equity prices must ultimately reflect and compensate investors for that risk or no one would hold them in their portfolio.”

I’m not sure where that “must” comes from: maybe it’s some kind of corollary of the efficient markets hypothesis. Investors certainly hope that returns on equities will be commensurate with the risk that they’re taking. But there’s no rule saying that any given asset class will “ultimately reflect and compensate” those hopes. After all, if there were such a rule, then really there wouldn’t be any risk at all!

This has nothing to do with the efficient market hypothesis. We could still have rules for things that are inherently uncertain (just think about quantum physics or the Heisenberg uncertainty principle). There is nothing that says that the equity premium MUST be around 5% in the future, it is just our current understanding of it that allows us to forecast this. Sure, some factors are likely to reduce the premia, like taxes, transaction costs, and etc, but saying that the market premium is zero seems a bit of a stretch to me.

GFC and bonuses

This is a really interesting post by Emanuel Derman. I think he is spot on that one of the main problems with the current system is not high profits per se, but actually that these profits are earned largely because of the implied backing given to banks (and the overall market) by the government.

Next week I'll discuss options in class. I think I will use this as an example to talk about puts.

PS - The first time I read GFC I thought it was something like the "Global Fighting Championship" rather than "Global Financial Crisis"...

So Close... And Yet So Far

Perhaps THE biggest question in Finance is what makes expected returns vary from one security to the other. The idea that getting higher expected returns cannot be generated without bearing more risk has driven the revolution and spurred a million papers, either trying to show that it works or it doesn't.

Avanidhar Subrahmanyam has just released a paper on SSRN in which he reviews many variables and methods that people have used to predictor returns (like P/E, size, liquidity, etc.)

He writes "our learning about the cross-section is hampered when so many predictive variables accumulate without any understanding of the correlation structure between the variables, and our collective inability or unwillingness to adequately control for a comprehensive set of variables."

With so many people, testing so many variables, with so many different methods, it is often difficult to really know whether a given variable can truly predictive future returns or it is just reflecting correlation with something else.

It would be nice to see a paper trying to run a "horse-race"of lots of variables at the same time (I mean a lot, not just 4-5).

PS - The article cited that shows that garbage production in the US is a better proxy for consumption than standard measures is really cool.