Soylent Green is Made of… Profit!

October 12, 2011

“People Over Profit!”

I keep hearing and seeing this phrase and can’t help but think of it as a caricature of college-stoner, Marxist-lite political economy.  It’s understandable that it would have gained traction among liberals of a certain streak: it’s pleasant, alliterative, and fits nicely on a bumper sticker.  But I do hate to see tens of millions of dollars of our nation’s collective (and publicly-subsidized) liberal arts education fail in the face of a catchy slogan.  Aren’t those of us with training in the humanities supposed to be, you know, enriching society with our critical thinking?  Wasn’t this sort of why those classes exploring the intersections of Japanese manga, the Cold War, and post-queer neo-colonial theory were worth spending several grand on, even though they didn’t exactly have a “practical” application?

How, exactly, does one put People over Profit?  Well, a good first question is: to whom is this exhortation addressed?

Any business consists of Owners and Employees.  Owners are the people whose capital is deployed (and risked) in conducting the affairs of the business, and who ‘control’ the business in the sense that they have certain contractual rights that are usually specified in the legal documents that govern the form of the business.  Employees are the people who actually do the work of the business from day to day, and who ‘control’ the business in the sense that they perform certain functions that interface with customers, suppliers, or the like.  It’s possible to be both an Owner and an Employee, say, if you’re a partner in a professional practice, or a shareholder of the corporation for which you work.

However, for modern businesses of sufficiently large size and scale – let’s call them, for the sake of argument, Evil Global Corporations – it’s unusual for an Employee individually (or all Employees collectively) to own enough of such a business to be an Owner in the sense that I describe it above.  The market value of the equity of Exxon Mobil Corporation – your typical EGC if ever there were one – is approximately $370 billion as of the moment I write this.  If you owned more than a vanishingly small percentage of this business, for how long would you choose to be an Employee instead of a Happy Retiree?

(As an aside, the distinction between Owners and Employees in the EGC gives rise to a whole host of complications that fall under the heading of “Principal-Agent Problems” — i.e., how do Owners who are not Employees get Employees who are not Owners to act in the Owners’ interests?  This subject is far deeper than I intend to cover here.)

So, to my original question: is the exhortation to put “People Over Profit” directed at Employees, Owners, or both?

It would be pretty fatuous to make this demand of Employees.  Imagine marching into a restaurant and demanding that your waiter put People Over Profit by serving you dinner for free.  Or staging a sit-in at Wal-Mart (another EGC!) until the Assistant District Sales Manager, the highest-ranking Employee you could find, gives you a discount on some clothing you really need.  It turns out that we tend to use words like “illegal” and “embezzlement” when Employees put People Over Profits.  So that can’t be the request.

What about Employees who have really fancy titles, like Chief Executive Officer, and who happen to be personally Rich?  Well, why does that change the analysis?  Should they be allowed, even expected, to give away the Owners’ property?  Perhaps if to do so were actually in the best interests of the Owners – but, in that case, isn’t it clear that the demand should be made directly of the Owners?

By the way, it doesn’t help if the Employee really passionately believes it would be in the best interest of the Owners to give away their property, but the Owners aren’t enlightened or compassionate enough to agree.  This is left as an exercise for the Reader.

So who are the Owners of the EGCs and their smaller but perhaps equally evil counterparts?  For publicly-traded corporations, it’s relatively easy to obtain a first-order answer.  Here’s an example for Bank of America Corporation, today’s poster child for corporate treachery.  The first-order answer for Bank of America, like most EGCs, is: “a whole bunch of financial institutions on behalf of their clients, and investment vehicles like mutual funds, exchange-traded funds, and hedge funds.”  In aggregate, the answer looks something like this.  But this first-order answer isn’t helpful.  A mutual fund, for instance, is itself owned by many Institutions and Individuals.  And who are these Institutions?  They may be endowments, foundations, pension funds.  And the Individuals?  Maybe the Rich… but also maybe (hopefully!) middle-class folks through their 401(k)s.

Point is: the Owners of EGCs come in all sorts of shapes and sizes, and serve a variety of constituencies – some of which sound Nice, like Retired Teachers; and some of which sound Bad, like Rich Financiers.  In this sense, it’s also fatuous to demand that Owners of EGCs put “People Over Profit” because, well… aren’t there people at the end of this chain, too?

To the extent that people are relying on the stock market to help them save for retirement, or were able to help afford college thanks to a university’s endowment, they are also just shouting at themselves.  But I suppose we all contain multitudes.

Fortunately, we have a more coherent framework at our disposal for expressing our desire that stuff be taken from some people and given to other people, whether the former party likes it or not – we call it Taxation.

“Tax Corporations!” is a marginally more coherent rallying cry than “People Over Profit” – but since Corporations are owned by People, we can reduce this even further:

“Tax Some People More Than They Are Currently Being Taxed!”

Not exactly the world’s most novel agenda for social justice, is it?  But at least it’s a prescription that can be coherently debated.

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Try To Remember

September 30, 2011

It has been quite a while since my last update, Gentle Readers.  August and September decided to throw just a few curveballs at the financial markets, so my capacity for what I call ‘discretionary thought’ has been rather limited.

I’d imagine that the market’s daily gyrations mean little to people outside the investment profession – as, generally, they should.  As I’ve mentioned before, it partially amuses and partially saddens me to hear the portentous tones in which talking heads typically describe a daily rise or fall in the Dow of an essentially insignificant magnitude.  A claim such as: “the market was down ~0.5% today on renewed economic concerns” has about the same information content as: “Candidate X leads Candidate Y in polls by 2%.”  Political pundits typically have the decency to note the margin of error of polls that they cite, although they may not stop from drawing conclusions that are unjustifiable in light of it.  Financial pundits, by contrast, rarely contextualize the day’s movements in the market.  There isn’t always an explanation for why a market index fluctuates by a modest degree.  Sometimes there are just more buyers than sellers, and sometimes there are more sellers than buyers.  That’s it.

How would I better contextualize daily changes in the stock market?  Thanks to the wonders of the Bloomberg Professional data service, it takes me approximately three seconds to pull the daily percentage change in the S&P 500 for the last thirty years.  The average daily change, between 1/2/1981 and 9/30/2011, is 0.03%.  Three basis points!  The standard deviation, however, is 1.15%.  Let’s put to one side the question of whether or not daily stock market returns follow a statistically normal distribution and assume that this is a fair approximation, except for the issue of “fat tails” (i.e., events that in fact happen more frequently than “never in a million years,” notwithstanding the claims of statistics).  The implication is that we should generally be unmoved by daily changes of +/- 1%, and should throw pies at anyone who claims that these fluctuations are necessarily driven by some Big Economic Theme.

But when market indices fluctuate by several percentage points each day, it’s a bit more momentous.  It also used to be relatively rare.  Let’s define as “noteworthy” a daily change of +/- 2.3% in the S&P 500 index.  This represents about two standard deviations of difference from the average.  We’d expect to see moves of this magnitude only about 5% of the time, i.e., relatively infrequently.  In my analysis of 7,760 trading days, there are movements of this magnitude on 360 of them (4.6%).  So it seems reasonable to pay attention to them.

What’s remarkable to me is how these 360 “noteworthy” days are distributed over time.  We might naively assume that, over 30 years, there would be about 12 per year, or one per month.  But the market doesn’t work that way – volatility tends to beget volatility.  These noteworthy days are in fact quite concentrated.  There were 29 of them in 1987, but only three in total during the calmer years of 1992-1996.  There was another spike in 1998, related to the Russian debt crisis, and another in 2000-2002 related to the dot-com boom and bust.  There were zero noteworthy days from 2004-2006.  Ah, that happy, golden, bygone era.

Consider this: in 2008, there were 63 noteworthy days, of which 46 occurred in the final four months of the year.  This is not news to anyone who lived through those dark days, but it is staggering when considered in historical context of what ‘ordinary’ volatility should look like.

The market remains at an elevated level of volatility, having notched 17 noteworthy days through the end of the third quarter of this year.  The S&P 500 has lost just over 12% of its value since the end of July, which will certainly shock some people when they see their next 401(k) statement balance.

I tend to think that Wall Street, like a college extra-curricular group, has an institutional memory of no more than four years, so I suspect we’re approaching a phase where professional investors will become to some degree desensitized to historically ‘extraordinary’ volatility.  I don’t have a good guess as to what the implications will be.

Hold on to your hats!


Jameson on the Rocks

May 16, 2011

The past few weeks have been rather Busy for your humble correspondent, which is not to say that they have been Unpleasant but rather that they have allowed precious little time for reflection and synthesis.  I can’t tell when I’ll be able to resume a more regular schedule, but rest assured that I will feel at least some pangs of guilt the next time an evening is spent with America’s Next Top Model on DVR instead of with my Dear Readers.

During one of these recent Busy weeks, I had the pleasure of taking a brief business trip to Dublin, a place I last visited as a student just under a decade ago.  It was a treat to be back, not least of all because I now had the novel combination of comfortable lodging and disposable personal income.  I realized that this was the first time I had revisited an international travel destination after any meaningful gap, so it was impossible to resist the temptation to compare notes with my memories and seek out familiar streets and sights.  I was pleased to have retained enough of a sense of the geography to project that typical city-kid confidence and purpose even in aimless wandering; within an hour of my first adventure outside the hotel, I was asked for directions by American tourists.  (My guess would have been correct, but I punted.)

I don’t at all mean to downplay the distinctiveness of Dublin, but my overarching conclusion was that it felt vaguely more “American” than I had remembered.  Some of the parallels were superficial and amusing (e.g., gourmet burger franchises, white people with dreadlocks) but others more ominous (e.g., foreclosed houses, moth-balled construction projects).  I remember how shocked I and my fellow American students were at the lack of conspicuous obesity that is such a hallmark of travel within the States.  Based on my extremely non-scientific observation from a few hours of walking and pubbing, however, I’d posit that the gap has narrowed as the Irish, perhaps, have widened.

And of course there was the economy.  During my summer as a student, the Celtic Tiger was somewhat wobbly on the back of the post-Dot Com global contraction (particularly in IT, which had become one of the country’s strengths) but it was still fundamentally sound.  Now… well, even the cab drivers wanted to chat about negative home equity.  My reception at the border could only have been more palpably chilly if instead of describing my profession as “Finance” I had opted for “Smothering Cute Animals.”  Young Americans are often wise to pretend to be Canadian if they happen to be abroad during moments of geopolitical instability.  I think from now on I may offer something squishy and believable in lieu of my actual business purpose; aren’t I, after all, part of the new media by virtue of this site?

I haven’t studied Ireland’s public finances (it’s hard enough to analyze enterprises that aren’t run by politicians) but the contours of their situation will be familiar to most observers of the developed world: gross misallocation (in hindsight!) of capital to housing and construction, whose asset values kept rising until they didn’t; insufficient capital to absorb losses at highly-leveraged financial institutions; sudden structural dislocations in labor markets; prohibitively expensive entitlements but no dry powder for countercyclical fiscal policy; etc etc.  Some sort of rationalization is inevitable, but I don’t have a view on when or what will trigger it, or how it will play out in practice.

I would, however, caution against counting Ireland out.  In my occasional conversations with businesspeople and with Joe Soap (again, an extremely non-scientific set of data) I was struck by how not-angry it seemed that people were about the situation.  Their tones were generally sober and pragmatic – certainly not optimistic – but inflected with a sense of collective responsibility.  The narrative was not that the country was screwed by, take your pick: greedy bankers, incompetent government, reckless consumers, or some other Other.  It was more like that the country had had a grand old bender and now everyone needed to clean themselves up.  Assuming that my reading is fair, this wouldn’t change the vast scale of the problems that Ireland (and many of the world’s governments, i.e., people) have ahead, but it would give me more hope that a solution might be reached there before it’s reached in a country where folks take to the barricades to protect the social entitlements that they refuse to pay for.

Slogans and economic dogma aren’t going to fix the massive structural problems with the world’s economies.  Patience, pragmatism, and a sense of collective responsibility, however, seem like constructive places to start.


Other Than the Crash, Captain Smith, How Was the Cruise?

April 5, 2011

I wrote recently about the importance in investment analysis of distinguishing between the recurring cash flows of a business and those variations in earnings that are more properly attributed to cyclical factors or one-off developments.  In practice, this is often easier said than done, particularly during periods of economic weakness.  To name a few examples, recent investors in newspaper publishers, telephone directory services, and video rental chains may now be wondering if their expectations for performance during a ‘normal’ cyclical downturn obscured signs of fundamental, secular changes to the viability of particular businesses.  This type of thinking is also important for companies themselves.  Critical decisions from managing daily cash balances to budgeting for capital expenditures to financing the enterprise as a whole depend on a sober assessment of the typical timing and quantity of cash flows.  One might think this is common sense (it is) – but human vulnerability to cognitive bias, to say nothing of corporate politics, introduces ample opportunity for error.

My motivation for this discussion was the scary, if not surprising, suggestion that a thoughtful analysis of the sources and sustainability of government revenues has been conspicuously absent from the debate over how to fill and distribute the public purse.  There are fair and important questions of principle involved in how we think about income distribution, income redistribution, and the role of the state as intermediary in that process.  But, to me, these questions are overwhelmingly less important than whether the liabilities the government currently has (and those it may want to incur in pursuit of future social objectives) are likely to be satisfied by the normalized cash flows it can reasonably anticipate receiving.  If not, we are not just rearranging the deck chairs by engaging in principled debates; we’re wrangling over the buffet menu for the Titanic’s second voyage.

(Sidebar: I prefer not to tip my hand too much as to my own thoughts on such principled debates, but since it’s fair to consider my cognitive biases – even though my thoughts are continually evolving – I’d say Matt Yglesias’ bullet points and Wil Wilkinson’s précis are collectively a good first approximation.)

As all levels of government debate their budgets for the next fiscal year, I’d encourage readers with curiosity and time to look through the proposals in some amount of detail.  An enormous amount of human effort goes into the production, analysis, revision, and execution of the proposals contained therein, so it’s a pity that so few voters are actually aware of the scope and complexity of such an undertaking (or so I assume; I would be happy to be proven wrong!)  Honestly, I think that American citizens should be given a national holiday during which they are required to read the Federal budget in its entirety, all supplemental charts and footnotes included.  (As a corollary, if it takes the Average American two weeks to read the budget, and the economy needs to shut down for two weeks as a result – or if the Average American is unable to comprehend the budget given any amount of time – that should tell us something!)   At a minimum, maybe this should be a requirement for claiming any sort of income tax refund or, in the case of high-income earners, claiming an effective Federal tax rate anywhere south of the 25% mark.

Civic duty aside, anyone who enjoys a gripping and timely work of fiction will find governmental budgets hard to beat.  Consider, for example, the government’s forecast of future tax revenue – it speaks volumes, particularly in the context of our earlier discussion of ‘mid-cycle’ cash flows.

I am only going to focus on the column for personal income taxes, which should correlate very strongly to corporate income taxes (insofar as economic growth drives both personal and corporate incomes) and social insurance receipts (which are a function of wages).  And I’m only going to make one point:

The forecast for 2010-2016 is that individual income tax receipts will double over six years, implying an annual growth rate of approximately 12%.  Some of this growth will be a function of the economic pie growing, and some of it will likely be a function of greater marginal tax burdens.  (Since these are nominal quantities, some may also be driven by inflation – although the government forecasts 2% inflation indefinitely.)  Based on some back-of-the-envelope math, I am extremely skeptical that anything near this growth rate has been achieved over a six-year period in recent economic history.  As you may remember, sometimes the economy contracts, which can really screw with a virtuous cycle of continuous compounding. Bear in mind that this is the same forecast that shows us running trillions of dollars of cumulative deficits over the same period.

If you believe that the economic growth of the past decade was to any material degree a function of: (1) unprecedentedly cheap and accessible credit, particularly for American consumers; (2) unprecedented opportunities for American corporations to reap the low-hanging fruit of globalization, which has largely been reaped; and (3) the windfall gains realized by a small number of individuals and institutions that were fortunate enough to sit atop enormous stacks of leverage and not lose — the trillion-dollar question ought to be: are these more properly considered recurring cash flows or extraordinary cash flows?

If the former, you should be betting your entire net worth on Corporate America right now.  If the latter, you should be really worried.

(Legal Disclaimer: That said, please don’t bet your entire net worth on anything!)


Next to Normalized

March 28, 2011

Investment analysts are trained to (try to) understand the drivers of the economic performance of the companies they follow, and to translate that understanding into a view on the valuation of those companies’ securities (i.e., stocks, bonds, and the like).  In theory, this is a pretty straightforward exercise.  A company’s securities represent claims of varying priority on its assets, which correspond in turn to claims on the expected future cash flows derived from those assets.  The challenge in practice, of course, is that forecasting the future is difficult; and even if such forecasts were perfectly predictable and widely known (i.e., so that the market had no disagreement about what they are) the market can be fickle in how it prices future cash flows at any given time.

Readers familiar with very basic concepts in corporate finance can probably skip this, as I won’t really get to My Point until the next post.  I think this will be helpful background for the rest of the audience, however.

Imagine two companies, A and B, that are absolutely identical except that they exist in parallel universes.  Imagine them as exceptionally unglamorous companies: say, manufacturers of dental floss.  Assume that, year in and year out, they generate about the same amount of annual free cash flow: this is a term of art, which essentially means the amount of cash earnings that are available to distribute to company’s creditors and equity owners, and to pay taxes, after setting aside an appropriate amount of those earnings to reinvest in the business (for example, to replace depreciating equipment) in order to continue generating that same level of cash earnings (the term of art would be “maintenance capital expenditures,” which we’ll also assume is about the same each year).

We would expect A and B to have virtually identical valuations in the market, since their assets produce identical levels of free cash flow and are expected to do so indefinitely.  If the companies borrow money, clearly some of that valuation would represent claims of their creditors on the free cash flow of the companies.  But, in general, we wouldn’t think of A and B as having fundamentally different values as enterprises just because A and B have different amounts of debt; the salient difference would be what proportion of that value is attributable to creditors and equity owners in each case.

Imagine that the fates of A and B diverge as you are reading this.

In A’s universe, there is a surge in demand for dental floss as the result of an unusually troublesome corn harvest that experts warn, as summer grilling season approaches, is much more likely to become stuck in your teeth.  Such corn harvests are once-in-a-blue-moon phenomena, thanks to advances in modern agricultural science.  But we have every reason to believe, when the books are tallied for the year, that A will have doubled its free cash flow relative to 2010.

In B’s universe, happily, we also expect B to double its free cash flow in 2011 relative to 2010.  But, in this universe, the surge in demand for dental floss is due to a nationwide oral hygiene panic!!  We’ve finally gotten religion about flossing.  Prominent dentists make the rounds on cable news and morning talk shows, warning of newly-discovered dangers of gum disease.  (Impotence! Death!)  Congress declares War on Plaque and appropriates $50 billion of Federal funds to fight it.  Professional-class parents compete for status through the quality of their children’s gums.  (Harvard is watching!)  And when hip-hop stars rap about flossing, they really mean it.

Each company will report the same free cash flow for 2011.  But should the market still ascribe the same value to each enterprise?  Our intuition is clearly no.  Company A seems to have experienced a nice windfall, but we don’t expect that its ability to generate cash flow has changed meaningfully.  It should more or less go back to the same predictable performance it has always delivered.  Put another way, it’s hard to imagine the market will be expecting a once-in-a-blue-moon corn harvest every year.  On the other hand, Company B seems to be riding a major structural change in demand for floss.  In the short run, it may well max out the capacity of its factories.  In the medium-to-long run, it may consider investing in new factories, going to market with different products, consolidating with other operators – all while potentially fending off competition from new entrants.  The Company is clearly on a different trajectory in terms of its likely ability to generate free cash flow in the future, even if we’re not sure what exactly it will be.

This example illustrates why investment analysts attempt to distinguish between recurring and non-recurring drivers of companies’ financial performance.  Related dichotomies in the jargon would be normalized versus reported earnings, and earnings excluding extraordinary items versus including them.  These drivers may play out in a particular quarter or, as in my example, fiscal year; but they may also play out over a longer time horizon.  For companies in highly cyclical industries, analysts often try to deduce a notion of mid-cycle earnings, to mitigate the temptation to take an overly optimistic or pessimistic view of companies’ potential to generate future free cash flow just based on where in an economic cycle we happen to be.

Part of the fun of investment analysis is that companies like to argue that negative performance is generally due to non-recurring factors — and that they are actually brilliant managers if earnings are measured on a Double-Secret-Adjusted basis that, in the company’s unbiased view, represents a true picture of the earnings power of the company.  When performance is unusually positive, however, the brilliance of management needs no further qualification.

Why do I bring this up?

Generally, I think it’s useful to distinguish between the recurring and non-recurring factors that influence one’s life in various ways.  Is your credit card bill high because you just moved into a new apartment, or because you are updating your wardrobe for every season?  Are you striking out romantically because you haven’t been compatible with your last few dates, or because there’s some deeper barrier to intimacy?  This is common sense wrapped in Wall Street jargon.

Specifically, though, the WSJ had a brilliant piece this past weekend that argues that the absence of this type of analysis from debates about public finances, taxes, spending, the deficit, etc., has helped bring America to its current precarious fiscal position.  Partisans of all stripes are guilty, which made this essay a refreshing if grim change from the typical rehash of religious arguments about what constitutes a “fair” distribution of income or a “right” size for the state.

As a starting point for my own opinions, which I’ll get to next time, I’ve provided the background above to show why I think it’s troubling (if not surprising) to consider that those in charge of the public purse consistently make the rookie analyst mistake of confusing the self-interested account of Double-Secret-Adjusted earnings with a more sober view of normalized financial performance.

If such mistakes would get a lowly analyst fired, why not our legislators?


Staying Sharpe

March 12, 2011

It’s hard to make decisions in the face of uncertainty, but often we must – whether in the case of our investments or our broader lives.  I find it useful to apply concepts from finance as I reflect on my decisions and prepare to make decisions in the future.  In part, this is because I’m lazy: I get paid to think this way already.  But, unromantic though this may sound, aren’t we all investment managers for ourselves?  We invest our resources (our time, attention, energy, skills) in the hope of achieving some sort of returns (perhaps happiness, comfort, companionship, pleasure) that are in all cases subject to fundamental uncertainties and disruptions.  If we accept this metaphor, perhaps it’s reasonable to think that we could learn something by reflecting on how an investment manager makes her decisions, and how her skill would be measured by others.

Roughly two-thirds of this post will be basic finance, in which I’ll take some shortcuts with your permission.  If you’d like to fast-forward to the punchline (punchparagraphs?), search for ‘dolphins’.

Obviously one important question to us as investors is: what rate of return do we expect to get on the investment?  Mechanically this analysis is pretty simple – it’s a question of cash flows in versus cash flows out, and their respective timing, which a computer can calculate in tiny fractions of a second.  Bear in mind that by treating the future cash flows, the probability of realizing those cash flows, and the time horizon associated with their realization, as discrete and knowable in the examples that follow, I’m glossing over 95% of the art and science of investing.  Let’s just assume for now that we can.  Do not try this at home.

Suppose we buy a piece of paper for $10 today.  We believe there’s an equal probability that the paper will be worth $30, $15, $10, and $5 in one year’s time, and that no other outcome is possible.  We could take a weighted average of those outcomes (i.e., 25% * $30 + 25% * $15 … ) and conclude that the expected (i.e., probability-weighted) value of the paper in one year is $15.  Our expected return would be $5, since we bought it for $10, and so we could think of our return as 50%.  If we wanted extra credit, we’d also look at what return we could have earned on a risk-free investment over the same time horizon.  The yield on a one-year Treasury bill is about 0.23% as of this writing, so we could have earned about a whopping two pennies with our cash if we had not chosen to buy the paper instead.  So we’d really think of our expected ‘excess’ return as being the $4.98 difference between the expected return on our investment and return on a risk-free asset (i.e., $5.00 – $0.02).

A second important question is: how risky is the investment?  Suppose we have two pieces of paper, Paper X and Paper Y.  Paper X will be worth $11 or $9 in one year, with equal probability (i.e., the expected value is $10).  Paper Y will be worth $20 or $0 in one year, also with equal probability, so the expected value is also $10.  Even though each piece of paper has the same expected value, the difference between them is clear.  Paper X has a very tight range of outcomes, but Paper Y is either going to be a home run or an easy fly ball for the outfielder.  Intuivitely, Paper Y seems much riskier, even if we don’t have a well-defined notion of risk.  Fortunately for our intuition, one measure of the risk of an investment is the standard deviation of its expected values (or returns), which essentially computes how wide is the dispersion or range of possible outcomes with respect to the expected outcome; the wider the dispersion, the higher the standard deviation.  The standard deviation of the possible values of Paper Y will clearly be higher than that of Paper X, which accords with our intuition that it has more risk.

The marriage of these concepts – expected return and the risk associated with that expected return – is the core of investment management.  One powerful intuition is that if we have two pieces of paper with the same expected return, we generally prefer the one that gets us there with less risk.  (If you want more extra credit, though, think about situations where that might not be the case.)  Similarly, if we have two pieces of paper with different levels of risk, we would generally demand a higher expected return on the riskier piece of paper in order to prefer it over the less-risky one.  If you would like to see me twitch uncontrollably, say something like, “higher risk means higher return” – a tragically common colloquial bastardization of the preceding concept.  The kernel of truth is that you should demand to be compensated for the risk you take, so a higher-risk investment should have a commensurately higher expected return.  But to see the distinction between the kernel and the bastardization, compare picking up a dollar from the sidewalk with picking one up in front of an oncoming train.

We can use these concepts to characterize the historical performance of investments, and investment managers by extension.  We could look at the manager’s performance over time, e.g., the annual return of her portfolio of investments.  For extra credit, we’d subtract the return she could have earned if the portfolio had been entirely in risk-free investments, which would produce the annual ‘excess’ return of her portfolio.  We could derive a notion of the expected return of her strategy just by taking the average of her annual excess returns.  We could derive a notion of the risk of her strategy by taking the standard deviation of her annual excess returns.  We could even calibrate the returns of her strategy relative to the risk of her strategy by dividing the first quantity (return) by the second (risk), since we’re expressing both quantities as annual percentages.

The result is known as the Sharpe Ratio, which essentially captures how much excess return an asset, strategy, or portfolio generated (or is expected to generate) per unit of risk.  It gives a way of normalizing investments that may have very different return expectations.  An investment with an expected return of 2% and standard deviation 1% would have the same Sharpe Ratio as one with an expected return of 10% and a standard deviation of 5%.  A higher Sharpe Ratio suggests that you are getting more “bang for your buck” when you take risk.  Going back a few paragraphs, assuming Paper X and Paper Y sold for the same price, an investment in Paper X would have a much higher Sharpe Ratio than one in Paper Y.  The Sharpe Ratio doesn’t tell you which of a set of investments is better, but it helps you assess how well compensated you are for the risk you have taken or expect to take.

Which brings me to dolphins.  They actually have nothing to do with what follows, but I needed to pick a word that wouldn’t show up anywhere else in this post.  When I reflect on how I’m managing my portfolio of investments in myself, I find the Sharpe Ratio to be a useful framework.  I think I’ve managed my life to an extraordinarily high Sharpe Ratio.  I’m generally very happy and comfortable, and I’ve been growing my personal capital (i.e., not just money; my rich memories, experiences, network of relationships, professional skills, opportunities, etc.) at a solid rate.  At the same time, I’ve taken very few significant risks, and I think I’m very well insured against downside – again, not just literal insurance; I think my strong relationships with family and friends are like ‘insurance’ against negative experiences like loneliness and fear.  Of course I have rough periods, like everyone, but my choices have been remarkable for how little volatility they’ve introduced for me.

I’m mindful, though, that a higher Sharpe Ratio is not necessarily better.  Some people are perfectly happy to live their lives pursuing incredibly low Sharpe Ratio ambitions – the aspiring actress, the serial entrepreneur.  The likelihood of failure is so much higher than the likelihood of success, and there’s a wide dispersion of outcomes under each of those headings.  These are lifestyles that will have a high standard deviatio in their actual past and likely future returns, but perhaps for them the pursuit of the highest possible ‘highs’ is subjectively worth the risk in a way that something as reductive as the Sharpe Ratio can’t capture.  (Actually, to reinforce my metaphor, it’s well known that the Sharpe Ratio is less useful when applied to non-Gaussian returns…)

The conventional wisdom is that one’s life migrates to a higher Sharpe Ratio as one becomes more of an adult.  A family, a mortgage, a professional reputation – as one acquires them, they (sensibly) constrain the amount of risk that one is willing to take.  If I look at how my own decision-making has changed, particularly in the last year, the remarkable thing to me is that I’ve gone in the opposite direction.  I’ve accepted a lot more volatility than I’m accustomed to (although, objectively, still not a lot!) in pursuit of uncertain higher-highs: relationships that might grow deeper, career trajectories that might be more rewarding, investments in people and causes that might make a big difference – or, in all cases, might not.  The outcomes all remain to be seen, but now that I’ve proven to myself that my return on risk has historically been pretty good, I’m ready to fly a little closer to the sun.


A bourse is a bourse, of course, of course

February 14, 2011

Is there something about the Big Board that drives otherwise-reasonable people batty?

Last week, merger talks between NYSE Euronext and Deutsche Börse were confirmed.  A handful of friends and relatives, whom I consider a reasonably representative sample of informed and engaged Americans, expressed concerns that I’ve subsequently heard raised by a variety of public figures.  Roughly, the issue boils down to: is nothing sacred in America?  Are we really going to allow foreigners to snatch up such a critical piece of financial infrastructure?  I’d wager, though, that most people have no more than a vague sense of how a stock exchange makes money.  I won’t go into detail here, but suffice it to say that exchanges now more closely resemble technology firms than august financial institutions.  If IBM and Sony were to join forces to develop new technology, reduce costs, and improve efficiency for customers, I wonder whether it would elicit such a strong knee-jerk response?

Senator Chuck Schumer decided to take a break from dealing with the couple of small problems facing our great nation to opine on the marketing strategy of the prospective combined company, as reported by the NYT among others: “It is totally logical to keep the N.Y.S.E. name first. If for some reason, the Germans sought an alternative option, it could be an indication that they are trying to wield an upper hand in the new company and would seek to make other business decisions that could go against New York.”

I mean… really?

I’m glad we’re at least temporarily shifting the conversation about Wall Street away from its incorrigible greed and recklessness, as if those weren’t also iconically American.  But it’s naive and counterproductive to think of business as anything other than global.  This is not to say that one shouldn’t ask questions about how global companies should be governed, or that it’s not sensible to view consolidation (a) among financial institutions or (b) among gatekeepers of infrastructure with some concerns about protecting the public interest.  Let’s just try to be reasonable even if there’s a big stone building with a big American flag on it in play.

I don’t know much about the financial rationale for the proposed merger of the exchanges, although some analysts seem to be excited about it.  I suppose optimists are untroubled by the ideas that: (a) you will have to pry profitable OTC derivatives businesses from broker-dealers’ cold, dead hands; and (b) that there is likely to emerge an incredible amount of competitive pressure via as-yet-unknown technologies to drive down costs in any product, as was the case in cash equities trading.  As usual, the Economist gives a wry précis, which is largely borne out by this compilation of analyst soundbites, for whatever those are worth.

The NYSE floor is nice for photo ops, and well worth a visit for any New York tourist or local.  And of course it gives all those CNBC anchors somewhere to stand while they try to look thoughtful and busy.  I doubt either of those valuable functions will be impaired as a result of a merger.