Luck or Skill? Paulson & Co. edition

I've just read on the FT that John Paulson (who made billions betting on falling US housing market prices in 2008) has warned of 25% redemptions in his $30bi AUM fund, following losses of more than 40% so far this year.

My MSc. dissertation was on whether technical analysis can generate abnormal returns or it is onlu due to "luck"- i.e. out of many possible combinations you are bound to find one that will have excellent results.

I usually use Warren Buffet as an example during my classes on market efficiency but maybe Paulson will be interesting as well. Maybe his profits back in 2008 were simply luck and shouldn't be expected to persist in the future?

The Importance of Entry/Exit Points when Investing

This graph on the NYT is very interesting in showing the importance of entry/exit points of investing in markets.

I wonder what investors that bought US stocks in 2010 will get in 20 years.

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.

Stress is Bad for your Trading Account

I read this a couple of weeks ago in the FT and forgot to blog about it. Basically Phillips and ABN Amro are teaming up to develop a bracelet to be used by traders that displays a warning if their stress levels are too high. The idea here is that investors might follow irrational strategies if they cannot think properly and should take a brake if they get to stressed out before taking any decisions.

This reminds me of a paper by Andre Lo in which he measures physiological characteristics of traders (like blood pressure) during live real trading sessions and finds significant correlation between changes in cardiovascular variables and market volatility.

Here is a video of how it should work. It looks like really good sci-fi stuff. I wonder if it might help in other situations, like preparing to an interview, approaching girls, or right before some World Cup penalty shoot-out...

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"...

Different Bear Markets over Time

This link here is old but I think it gives a pretty good comparison of the severity of crisis through time.

It is really amazing how big the Great Depression was. It must have been tough to live it through...