Location: Georgia Southern University, Georgia, United States

Tuesday, September 13, 2005

How Soon We Forget

George Santayana wrote, "Those who cannot remember the past are condemned to repeat it." (Life of Reason, Reason in Common Sense, Scribner's, 1905, page 284)

And so they do. On Monday, September 12, 2005, the Wall Street Journal carried a front page column titled, "How a Formula Ignited Market That Burned Some Big Investors." The story is about how a mathematical computer model used to price exotic credit derivatives based on correlations failed to capture the way the market actually responded to events in the credit market. The fault lies with both the model and its users, but the result was big money lost.

How soon we forget. It was only a few years ago that Long Term Capital Management was arbitraging credit markets with a sophisticated mathematical computer model based on correlations that failed to capture the way ... well, you know the rest of the story.

Models of markets can never be 100% accurate and are always the product of underlying assumptions that may or may not correspond to how the market reacts. Blind faith in their ability to work is a bad habit, and apparently a difficult one to break.

So the next time someone tells you he has heard of a mathematical computer model that uses correlations to arbitrage credit markets remember what Yogi Berra said, "This is like deja vu all over again."

Saturday, September 10, 2005

Politics as Usual

The Governor of Georgia has led the State legislature to repeal excise and sales taxes on gasoline. At the same time, he threatens retribution against gasoline retailers caught "price gouging." Let's see how this works, shall we? A Catergory 5 hurricane wipes out major southeastern oil port and adjacent refineries - oil and gas supply are signicantly reduced at a time when world supply can barely keep up with demand. Basic economic principles are validated as retail gas prices quickly rise in response to panic buying and decreased supply. Basic government knee-jerk response is also just as predictable - accuse sellers of gasoline who charge what people are willing to pay of "gouging" and threaten to prosecute them, making certain that gas suppliers from other regions have no incentive to reroute gasoline our way. And, to top it off, since the problem is a short-term shortage of supply, for good measure reduce the price at the pump so drivers will not be encouraged to conserve, keeping demand high.

It all rather reminds us of something H.L. Mencken once wrote, "Democracy is the theory that holds that the common people know what they want, and deserve to get it good and hard. "

Not that we don't like tax cuts, we do. But we prefer the permanent kind rather than transitory relief that distorts markets. Speaking of which, why is it that newspapers consistently refer to this tax rollback as "costing the government"? We have yet to see it characterized as "saving the taxpayer."

Wednesday, September 07, 2005

Even Homer Nods - critique of 8/23/05 WSJ column

The Wall Street Journal is our favorite newspaper. Being such big fans of the WSJ it pains us to see the paper commit a non sequitur. The August 23, 2005 Smartmoney Fund Screen article on Global Funds begins by asserting "It used to be a tenet of portfolio allocation that a well-diversified investor should maintain a careful balance between foreign and domestic funds, in order to avoid overexposure to slumps at home or abroad."

The column continues, "'s becoming less clear that mixing and matching funds by broad geographical categorization provides any protection at all." One assumes that since the topic is diversification, the idea of "protection" means from widely fluctuating returns. But what is the evidence cited to support the conclusion that geographical diversification is passe? - that the difference in returns over five years from different funds " little more than rounding error."

Well, concluding that diversification doesn't work anymore because the returns are similar is a non sequitur - it simply doesn't follow. Diversification is about reducing the volatility of portfolio returns, those ups and downs that cause investors to lose sleep at night. To say that investments that produce the same return over some period of time are equivalent is to ignore the risk of the investments entirely. The benefits of diversification are in risk reduction, not returns per se. To show that diversifying internationally isn't what it's cracked up to be requires showing that by some measure of volatility - variance or standard deviation of returns during the five-year horizon - there was no difference between the investments.

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