Sep 21, 2008

The Case Of The Missing Volatilities: A Disillusioned Capitalist's Rantings

A while ago, someone approached me with a business inquiry. He told me he was working as an investment consultant for Austrian savers who, being both risk-averse and unhappy with low yields from savings accounts, were, in his words looking for something like a "leveraged savings account", a combination of high returns and near zero volatility. That request made me cringe, and I politely let him know that I wasn't interested in doing business with him.

I somewhat pity the people who are consulting him; for they may sooner or later get what they ask for, but not what they want. What they want is a risk-free return above the rate of risk-free return. What they'll get is a smooth curve on some piece of paper. Because it would have been easy to give them a strategy that returns, say, 14 percent p.a. with near-zero volatility. For a few years, that is, long enough to collect some handsome fees. But you don't have to be a Quant for that - even you could have done that. Here's how:

First, find some event that you judge to be reasonably unlikely, like, snowfall on Christmas eve in Wels, Austria (my hometown.) I'd say there's a one-in-ten chance to that.
Second, find someone who judges more or less likewise and is willing to bet (not necessarily fairly) on the occurrence of the event.
Third, put your money in a savings account, and every year, accept the bet to the full height of your savings.
You're basically insuring your partner against the occurrence of a moderately rare event with all your capital. In essence, you're running an insurance company with a single insuree.
As long as things go well, you'll earn something like a 14 percent return every year (odds + savings account). How likely is it that things go well ? Your chance of surviving for five years is almost two-thirds; you can expect to go down only after seven years. Meanwhile, you'll chalk up almost zero volatility.

This may be the right place to mention that, according to a study by Credit Suisse/Tremont, the average return from hedge funds between 1994 and 2005 was about 14 percent before fees. And an often cited number for the average hedge fund's lifetime is five years. Now of course not all hedge funds close shop with total, or even large, losses. And most funds have far from zero volatility. So, uhm, I'm not implying a blatantly simple analogy here.

But I want to sharpen your senses to the fact that it's quite easy to smooth out the volatility from a capital growth curve. For a while. So if someone shows you a nice, smooth fifteen-year curve of 14 percent returns, please don't be impressed. He may just be one of four similar idiots, or frauds, who started out in the beginning. And for god sake don't hand over your money, at least if you can't take a qualified look under the hood to see what produces the returns. Also be aware that in many cases your opponent may be fooled by his own elaborate squaring-of-the-circle constructions, and may have genuine good faith in his strategy, so the terms idiot or fraud are probably a too harsh in most cases. He may loose all your money even if he's a nice guy.

The practice of gambling for small returns against large losses is generally frowned upon, since the tolerability of losses generally decreases stronger than linearly. That means a tenfold bigger loss usually is more than tenfold as bad for you.

And this brings us to last weeks events. Once again, the Fed and the US government demonstrated their determination to smooth out growth curves (gdp, stock market,employment), at the price of a small chance that things turn out really bad in the end (e.g. Fed losing political independence.) This has been going on since at least 2000, and even if the chance are small, someone is sooner or later going to lose their bets. The Fed has just acted like a man who'd learned he wouldn't get a raise this year and decided to make up for that by quitting his health insurance plan.

When I was in my early twenties (ca 1998), I turned from a moderate leftist into a firebrand libertarian. The demise of the eastern bloc, Japan's stagnation and the New Economy seemed proof to me of the superiority of free markets. I'm still much of a libertarian today, but I do not any longer make the mistake of confusing libertarian theory with the actual policies of self-declared free market advocates. I recommend reading books on the soviet system printed in the soviet union. It does wonders at giving you anew perspective on things you may read here and now.