Dictatorial Incentives

When it comes to running a country, non-hereditary dictators already have among the worst incentives. They are there to get what they can from their country while they still have control. They are going to be more short term oriented than a monarchy and much less responsive to the immediate well being of the people than a democracy. When it looks like they might lose control their incentives are even worse.

The recent news about Mubarak sends a powerful message to dictators.  "Don't publicly kill your citizens. Don't enrich yourself too much at their expense.  But if you have already done these things, you might as well fight to the death of your citizens and yourselves because it isn't likely that there will be a safe way for you to give up power."

These people have done horrible things, and from Egypt's perspective this prosecution makes a lot of sense. It attempts to quell the recent surge in unrest by bringing people who have done very bad things to justice.

But if Mubarak, a leader who voluntary stepped down, is being treated like this then other dictators are going to think twice before following his lead. They have very little incentive to surrender. Assad and Gaddafi probably don't see any way out at this point*, so they have no choice but to dig in. In Yemen Ali Abdullah Saleh might have changed his mind because he wanted to keep power over the promise of immunity, but it is also possible that he didn't think that he would have real immunity.

Before extending this simplistic analysis too far it should be noted that many dictators are crazy and won't always respond to changes in incentives (and even if they were sane, one particular person will not always respond significantly to a change in incentives). Still, systemic policies that stack the deck further against a good outcome are not desirable.

We can just be thankful that none of these misaligned incentives are immediately significant in the countries run by dictators who have nuclear weapons. 

*At this point it is questionable whether they should even be offered a way out. Preventing future bloodshed needs to be weighed against bringing past wrongs to justice.

Do normal Bloomberg users not use data?

These days, people who buy new PCs running windows will be purchasing a machine running Windows 7 64-bit. I don't have strong opinions on operating systems so this seems fine, except Bloomberg's excel API does not support 64-bit applications. When asked they don't give a data at which they'll start supporting it either.  So either no one in finance is buying top end new computers that benefit from the 64-bit architecture or only a very small percentage of users actually download Bloomberg's data into excel files for more complex analysis so Bloomberg hasn't felt enough customer pressure to make sure that their product is fully compatible with the majority of new computers.

Either way, it's really weird.

Freakonomics without the economics

Freakonomics was a fun book, and it got a lot of people interested in economics that wouldn't have been interested otherwise.  The podcast based on the approach taken in the book has highlighted a lot of very interesting research and has been a pleasure to listen to.  The writer Stephen Dubner runs the podcast and his co-author Steven Levitt occasionally co-hosts.

A recent episode "Death by Fire? Probably Not" shows what can happen when the economist is left out of the show. It was a podcast about fire safety done by someone completely unfamiliar with the economic concept of opportunity cost.  A new California regulation that went into effect this year requiring sprinkler systems in new homes was applauded as a natural step of fire safety regulation instead of analyzed from a cost benefit perspective. The additional cost of $4000 to $6000 dollars per house was not mentioned. With a national fire death rate of 13.2 deaths per million people, even if these regulations brought the fire deaths of those inside these houses down to zero it would be doing so at a cost of hundreds of million of dollars per life saved.

It's bad when normal journalists misses some basic economic idea that is important to their story, but it is worse when a journalist who has spent the last few years writing books about economics does it. 

For people interested in a fun economics podcast Freakonomics does have a lot of good episodes. However, Dan Ariely's Arming the Donkeys also covers economic topics and does a better job of challenging the ideas of its guests.

Invest in Education!

"Invest in education!" It is the rallying cry of many who think that more education spending is the silver bullet that is going to solve most of America's problems. However, the bullets seem to be hitting student's balance sheets more than America's other problems. In the past year, Mark Kantrowitz of FinAid.org claimed that the total education debt outstanding has passed the total credit card debt outstanding. Unlike credit card loans, these are loans that cannot easily be discharged in bankruptcy. These loans will follow students for the rest of their lives, potentially going so far as to allow lenders to go after tax refunds or a person's social security payments.  This is a debt overhang that cannot be solved by jingle mail*.

The confusing thing about education is that it is partially a private good and partially a public good. An educated person is be more likely to promote positive aspects of society by being a well behaved and productive citizen. Basic education is obviously very valuable, because a literate population is capable of many more things than an illiterate population. It is also necessary for most people to be trained in more advanced skills, since there is a level of educational attainment that it is important for a developed country to reach. In the past, economic growth has been associated with increases in education. Economists have documented this trend and like many forecasters they assume that the relationship that has occurred in the past will continue to hold into the future. However, the nature of education as a private good might be causing this correlation to breakdown. 

Education is also a private good because it serves as signal to other people of the student's qualities, and that signal only benefits the person holding the degree at the expense of those who don't hold a degree or those who hold a lesser degree.  Bryan Caplan suggests that the qualities signaled are work ethic, intelligence and perhaps even the conformity required for an employee to be a productive corporate worker. If education is being used mainly for signaling purposes, the limited number of degrees being given out by top colleges would be a feature and not a bug.  The value of adding on more slots at lower tier colleges is also low because lower tier colleges generally price themselves similarly to top tier colleges so that they don't look like they are lower tier.  

An important question is whether or not education is more of a cause behind students becoming more productive students or if the kids who are selected to become students were already going to be more productive in the first place.  One way to measure this is to look at the demand for university material by non-students. If many non-students thought they could receive most of the benefit of an education by attending lectures given at the top colleges and doing the work on their own time then we would see more security outside of lecture halls keeping non-students out.  ITunes would also be able to sell their lecture series for nontrivial prices that they are now giving away for free at ITunes U.  Another question is how much additional spending directed towards education helps. When inflation in education has increased at four times the rate of inflation since 1986, it should make people stop and think before deciding throwing more money at the problem is the obvious answer. 

If education is more about signaling than teaching, then it means that as spending increases most of that spending is merely being wasted on an inefficient status competition.  Perhaps this is why Peter Thiel has been calling education a bubble.  One way he is drawing attention to this bubble (while at the same time cleverly expanding his network for recruiting talent) is with his "20 under 20" program. This program involves paying 20 students to leave college for at least two years. One of the ingenious things about this program is that the applicants are being promoted as very elite students with articles about the program specifying that many of the applicants are from top colleges. If this program is repeated year after year and becomes fixed in people's minds as one of the most elite programs out there for aspiring entrepreneurs it should give the winners the status they were hoping to get from their college diploma. They will only go back to college if they think that they will really benefit from the education.

Those who agree with this general perspective and think bubbles should have direct tradable implications should review Steve Eisman's May 2010 Ira Sohn conference presentation about the for-profit education companies.  If there is a subprime of the education bubble it is probably the for-profit education companies. For-profit education has the unfortunate distinction of being among the lowest status providers because of their willingness to take almost any type of student in order to make a profit.  If people wake up to the idea that most of the value in colleges comes from increasing a person's relative status** and that these colleges are at the bottom of the totem poll, then the for-profits will be in trouble.

It's nice to think that education is a race to the top that everyone can win, but we shouldn't ignore that once we get near the top the real game starts to look more like king of the hill.

*The situation is more complicated than this for many of the people who took out multiple loans on their houses. It will also be hard for some of these people to walk away.
**Certain government workers who are merely trying to get additional certification in order to quality for higher pay might be the last to care until their compensation system is changed.

Links: The "Some people on the internet are wrong!" Edition

1. Naked Capitalism's april fools prank came 3 days late. Just to consider one of the most glaring errors of the letter, the author seems to have no idea that many academics earn money based on the value of their connections and knowledge from their governmental positions. Thus, their main patrons would be factions that might end up running the government. See Elizabeth Warren's use of weird metrics in order to make politically charged studies which led to her current position as a special advisor to the Consumer Financial Protection Bureau.

2. One of the bloggers at the Economist has no idea how hedge funds work. They are unable to tell the difference between a decrease in assets due to investors pulling money out of a fund and negative returns. To be fair, the blogger is apparently based out of Kansas City.

3. In one of the recent episodes of "To the Best of Our Knowledge", Lone Frank brought up understanding the "Coke/Pepsi" example as one of the main case studies of neuromarketing. The Coke/Pepsi example is derived from the Pepsi challenge, where the less popular Pepsi is preferred in blind taste tests, but Coke is preferred if the drinks are labelled. This leads neuromarketer proponents to believe that there is something special about the branding of Coke or memories associated with the brand that makes it more appealing than Pepsi and that this difference can be seen directly via brain scans.  However, these neuromarketers are missing a key fact that was pointed out in Malcon Gladwell's book Blink. Coke tastes better in the long run because the sweetness of Pepsi gets more annoying over time. Given this data, the experimental subjects used by neuromarketing analysts are probably associating the brands with their memories of consuming the actual product.  Advertising and other fond memories associated with a brand should also have a measurable impact on the brain that would be interesting to study in more depth, but it is kind of sad that the neuromarketing flagship study* is based on false premises.

*This label is based on how it was the one study that was brought up on the podcast and because it is the only study mentioned in detail on the wikipedia page for Neuromarketing.

Who Predicts Well - Does it apply to financial markets?

What makes a good predictor is a very interesting subject to those involved in financial markets.  Tyler Cowen highlights an excerpt from a piece by Dan Gardner and Philip Tetlock:

"…what separated those with modest but significant predictive ability from the utterly hopeless was their style of thinking. Experts who had one big idea they were certain would reveal what was to come were handily beaten by those who used diverse information and analytical models, were comfortable with complexity and uncertainty and kept their confidence in check."

Having one big idea might be a dangerous thing for money managers, but it seemed to work for some people who shorted the housing market.  The way to reconcile these two facts could be that the people who made money shorting the housing market weren't applying their one big idea about the future downfall of America or the idea that easy money is going to destroy the economy, but instead were the type of people who came to their conclusions about the housing market after studying various metrics and utilizing different analytical models.

It should be noted that just because the experts who are supporting their one big idea might be worse predictors in general, they may not be wrong in the long run. Those who favor a long gold strategy tend to have one big idea: You can't trust fiat currency (particularly the fiat currency of the United States), as throughout history all fiat currency has approached zero.  They see every sign of inflation as a sign that gold should go up in value and every sign of deflation as a sign that gold should go up in value.  Even though they have the wrong cognitive approach, over the past 10 years they've been right far more often than they've been wrong.  If someone marginally familiar with Tetlock's research decided to sell gold because they didn't like the arguments of people buying gold they would have lost a lot money.

On bearish journalists and bullish asset managers

"Any intelligent commentator will over time feel more comfortable from the bear position, just as most traders trade from a bullish bias.  There are more negative things that can be said in an intelligent way. The hidden order of markets that generally make things work is not easily described by a journalist.  The only consistently intelligent bullish commentary I've read has been from Niederhoffer and McKinsey. There is more money to be made buying assets than selling them short.  However, that doesn't prevent dedicated short sellers from making money."

This is an excerpt from an email I sent to a friend over four years ago. It's still rings true today, even if asset managers with a bullish bias have not has positive returns in recent years. There is only so much money that can be allocated towards selling assets short. If it is ever the case that short funds seem almost as popular as long funds, it probably means that it is time to load up the truck and buy equities.

Links: Japan's tragedy and some of its implications

1. A lot of videos of the horrific damage from the tsunami are going around. This one shows how the wave wipes out villages (Warning: Graphic) as it approaches the shore, while this video shows just how destructive a large amount of water can be to a city even when it isn't moving at huge speeds.

2. Some people are wondering how Japan will be able to finance its reconstruction.  Peter Westaway of Nomura expects rating agencies will "cut Japan some slack" for humanitarian/public relations reasons. While this will reduce the need for some institutions with strict rules to keep their money out of Japan it also means that the market could move well before the ratings agencies do.

3.  The Bank of Japan is flooding the market with yen. Weighed against this move and the government's new fiscal position is the repatriation of Japanese household's foreign investments combined with expected insurance payments that will flow into the country. These inflows help explain why the yen hasn't moved very much and has actually slightly strengthened against the dollar despite the huge economic shock that has sent its stock market tumbling more than any other two day period since 1987.

4. There appears to be less looting in Japan than in other recent natural disasters. One politically incorrect explanation is that groups of people with high IQ's are more likely to cooperate in prisoner's dilemmas. (HT: Garrett Jones

5. The biggest impact of this tragedy on America's future might in how it seems to be scaring people away from nuclear power.  If the situation at Japan's power plants gets any worse the future of nuclear power in America will be very dim.

What a naive long China strategy misses

People who go long China's economic growth by buying their equity index will miss out on a lot China's growth. Via the Economist I came by this interesting fact:

"Qiao Liu and Alan Siu of the University of Hong Kong calculate that the average return on equity of unlisted private firms is fully ten percentage points higher than the modest 4% achieved by wholly or partly state-owned enterprises."

While looking at this, it is important to note that this is just state owned firms and not firms with ownership by government officials. But the outperformance of unlisted firms does suggest that the average investor looking to go long China's listed equities are not participating in a large portion of China's economic growth. Marc Faber anticipated this as far back as 2002 when he wrote Tomorrow's Gold and made the analogy between China today and the United States in the 1800's. The 19th century United States economy grew a lot, but the opportunities available to foreign investors, mostly railroad stocks, didn't give foreign investors corresponding returns.

The beginning of the end for low vol?

Eric Falkenstein wrote one of my favorite books on finance, Finding Alpha. In this book, he goes over the typical lifecycle of market inefficiencies. Markets might mis-price volatility or Eurodollars or under estimate stock market daily reversals for an extended time period, but once people find out about it and have the tools to easily trade it the alpha available to investors in the know decreases.  In the same book and on his blog he also promotes his pet investment thesis: low volatility stocks or avoiding high volatility stocks. If CAPM is wrong and people are basically envious rather than risk averse then their main goal is to outperform the benchmark. Low volatility stocks offer no hope of outperforming the benchmark and in fact consistently underperform it during bull markets. Because of this they are subsequently undervalued and massively outperform during market turbulence.  Their risk adjusted return across stock market cycles is better than the index as a whole by over a percent a year. This doesn't sound like much, but a one percent growth rate differential matters a lot over the long run.

Recently, Falkenblog has been pointing out all of the people coming around to this point of view. As someone who wants to take advantage of this strategy in scale this is worrisome (Even if the prospect of being able to choose to apply this strategy via ETFs is also convenient). It is starting to look like the strategy is going to get crowded. The low volatility strategy probably isn't crowded right now, but it looks like that this cycle might be the time that it finally becomes popular enough to impact returns. If that's true, than that means that this cycle will see low volatility stocks underperform to a much lower extent but also fail to outperform to the same extent during the next bear market.

It will be interesting to see how many low vol ETFs are introduced and their subsequent popularity.  Measuring the AUM of low vol ETFs and funds is a good way to track just how popular the idea is getting because mentions in press and conferences will only matter insofar as they are reflected by the choices investors are making in their portfolios.