Things Never To Forget

'In finance... data are scarce and, more importantly, markets are arenas of action and reaction, dialectics of thesis, antithesis and synthesis. People learn from past mistakes and go on to make new ones. What's right in one regime is wrong in the next.'

'A little hubris is good. But then, when you're done modelling, you must remind yourself that you're theorizing about [individuals], and that, though God's world can be divined by principles, humanity prefers to remain mysterious. Catastrophes strike when people allow theories to take on a life of their own and hubris evolves into idolatry. Somewhere between these two extremes, a little north of common sense but still south of idolatry, lies the wise use of conceptual models. It takes judgement to draw the line.'
- E. Derman, My Life As A Quant


'In my first year I took an intermediate statistics class with a professor named Harry Roberts... But what I learned from Harry was a philosophy. He gave me an attitude toward statistics that has stuck with me ever since.

With formal statistics, you say something -- a hypothesis -- and then you test it. Harry always said that your criterion should be not whether or not you can reject or accept the hypothesis, but what you can learn from the data. The best thing you can do is use the data to enhance your description of the world. That has been the guiding light of my research. You should use market data to understand markets better, not to say this or that hypothesis is literally true or false. No model is ever strictly true. The real criterion should be: Do I know more about markets when I'm finished than I did when I started? Harry's lesson is one that I've passed on to my students over the 49 years that I've been a teacher.
- E. Fama, 'The best advice I ever got'

Fishing and Investing

One of my favourite books that is not about investing and yet, I feel, contains investment wisdom is The Perfect Storm (Sebastian Junger, 1997). Those of you who have read it (or even those who have suffered through the terrible film adaptation) know that it is the true story of a fishing boat that sank in the Atlantic in 1991, with spectacular explanation of the causes and processes that led to the tragedy.

I particularly like the following extract:

In a sense Billy's no longer at the helm, the conditions are, and all he can do is react. If danger can be seen in terms of a narrowing range of choices, Billy Tyne's choices have just ratcheted down a notch. A week ago he could have headed in early. A day ago he could have run north like Johnston. An hour ago he could have radioed to see if there were any other vessels around. Now the electrical noise has made the VHF practically useless, and the single sideband only works for long range. These aren't mistakes so much as an inability to see into the future. No one, not even the Weather Service, knows for sure what a storm's going to do…

But even if the boat doesn't get hit by a nonnegotiable wave, the rising sea state allows Billy less and less leeway to maneuver. If he maintains enough speed to steer, he beats the boat to pieces; if he slows down, he loses rudder control. This is the end result of two days of narrowing options; now the only choice left is whether to go upsea or down, and the only outcome is whether they sink or float. There's not much in between.

This is a great way to think about an underperforming portfolio. 'Danger can be seen in terms of a narrowing range of choices' - with the option to sell the underperforming stocks having passed, the portfolio now owns what it owns, and those stocks will bounce, or the manager will be sacked.

'The only outcome is whether they sink or float. There's not much in between.'

A Poem about EMH

To sense that every struggle brings defeat
Because Fate holds no prize to crown success;
That all the oracles are dumb or cheat
Because they have no secret to express;
That none can pierce the vast black veil uncertain
Because there is no light beyond the curtain;
That all is vanity and nothingness.

From The City of Dreadful Night, by James Thomson

There’s No Such Thing As Precision When Investing

"This makes perfect sense in theory. The problem is when investors assume a false sense of precision when using the correlation statistic or any relationship for that matter. It would be much easier to forecast the future movements of the various asset classes and individual holdings within a portfolio if correlations were static, but they aren’t. Correlations are dynamic."

More here.