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Another source of risk – the human brain

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This is an excellent article from Barry Ritholtz about how the human brain processes information. It starts with a political point aimed at one party, but really has nothing to do with politics.

His main points are:
“No. 1: We seek information to reinforce our beliefs.
No. 2: Selective perception prevents us from becoming fully informed.
No. 3: The ability to step out of ourselves to see the world from a different angle or perspective is hard.
No. 4: Emotions get in the way.
No. 5: Objectively measuring data isn’t our strong suit.”

While Ritholtz‘ point here is that our brains get in the way of making good investment decisions, the same clearly holds true for risk. In fact, looking at four of his five points, I would argue that the reality of human decision making is even worse than he says.

First, do we seek information that reinforces our belief that our investments are safe? Well we certainly don’t seek out the opposite. How many people who owned highly leveraged housing in the mid-2000’s comforted themselves with the knowledge that real estate “never goes down”? A bit of research in 2005 would have turned up three national level real estate declines of more than 20% in past 100 years. Looking on the local level, one would have found at least four significant, regional declines. All this was in the record before 2008, but how many people looked?

Selective perception is even more dangerous in assessing risk. Large losses in many asset classes occur at lower frequencies than gains. So any selective perception decreases our already limited ability to see risk.

I’ll skip point three, as it is well-covered in the article.

As to point number four, emotions getting in the way, this is, again, even more true for evaluating potential losses. Thinking about losing is uncomfortable, so we don’t do it. How many spouses don’t buy life insurance, not because they don’t love their families, but because they don’t want to think about death? (The answer: lots.)

Finally, his point about objectively measuring data is true, but I think it understates the point. Even if you are scrupulous in looking at all the past data regarding any given decision, you only see what has happened. You don’t see what could happen. And the worst that could happen is almost always far worse than what has happened.

Even if ur scrupulous looking at all past data, you only see what has happened-not what could. And… Click To Tweet

 

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Jerks and start-ups. As usual for the NYT, they get it wrong.

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The New York Times discovers Silicon Valley’s worship of youth over experience. As usual for the NYT, they get it wrong.

The problem is not young men, full of testosterone and bluster. It’s not “bro culture”. The problem is the feedback mechanism.

The problem is not 'bro culture'. The problem is the feedback mechanism. Click To Tweet

There are institutions that routinely handle men and all our associated problems. The military certainly seems to manage them, although, admittedly, its mission is a bit different from that of the average startup.

When I was helping manage the S.F. branch of an options market-making group, we had a lot of smart, energetic young men. There were many more all around the trading floors, working for other companies. As the experienced older man in my group (my nickname was “Gramps”, because I was 35), I could provide insight and advice. It might have helped on rare occasions. But the advice made far less impact than actual market experience. You’ve never seen a young man so chastened as immediately after he lost a bunch of money. Losses are the best teachers and losses happen all the time in the capital markets.

The markets, with their very fast and brutal feedback mechanism are a better teacher than any man or woman, no matter how grey their temples. You can add as many advisors or mentors as you like but none will teach as much as one deep, gut-wrenching trading loss. (Of course, if a young trader works at a huge investment bank, with their incredibly favorable order flow and massive assets behind them, he or she may be sufficiently insulated from his or her results, that the learning process is delayed.)

Meanwhile, in Silicon Valley, what is the feedback young CEOs are receiving? We regularly see articles about how great it is that they are successful at a young age. Forbes, for example, publishes a list of 30 young entrepreneurs under 30. The clear implication is that their youth is a value in and of itself. Silicon Valley both worships youth and discriminates against age, so these young people are less likely to be exposed to the views and experience of those over 50. Certainly, in the cases of some of the companies mentioned in the NYT article, investors are almost throwing money at these young entrepreneurs. No wonder they have a proclivity for blowing up companies.

If you’d thrown this sort of money and attention at the mid-20’s me, well, it would not have been pretty.

So how do we fix the flawed feedback mechanism?

  • Investors could surround these young men with seasoned execs and it might help.
  • Taleb would suggest they need skin in the game. The problem is that they appear to already have skin in the game in the sense that they own a lot of shares. But, based on the behavior observed, my guess is that they feel insulated from loss in some manner. Maybe they are already so rich, at such a young age, that it’s hard for any drop or error to cause significant pain.
  • Another solution would be to reverse recent trends and to start taking companies public more quickly, so the short-term gyrations of the stock price would be visible.
  • Or, investors could only fund young people with children, who’ve already learned to worry about the future. Also, they’d get so little sleep that “bro culture” would pretty much go out the window. On the other hand, I’m fairly sure this suggestion runs afoul of a bunch of anti-discrimination laws, so maybe we scratch one.

Perhaps, the New York Times article marks a shift in the culture, away from the devotion to youth for its own sake. I’m still waiting to see an article gushing about the top 50 execs over 50. But I’m “talking my own book” here.

 

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The beauty of bitcoin

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Coindesk notes that the Winklevoss’ proposed Bitcoin ETF rejected. What caught my attention was a quote from Josh Crumb, co-founder of GoldMoney and a former commodities strategist at Goldman Sachs. After indicating that Bitcoin cannot be regulated because it is fundamentally opposed to government sovereignty, he said:

“Bitcoin’s utility is that it cuts through sovereignty. It’s its own law.”

Bitcoin’s utility is that it cuts through sovereignty. It’s its own law. via @CoinDesk Click To Tweet

What is interesting here is that, yes, Bitcoin does “cut through sovereignty”. The beauty of Bitcoin is that it is a non-governmental currency, like gold, but also one that can be transmitted anywhere, any time. There is far less risk of being inflated away, which has been the fate of many, if not most, currencies. And it can circumvent capital controls and other regulation.

At the same time, it would be nice if the regulated entities with which we interact every day could realize some of the benefits and efficiencies of blockchain technology. The regulators are far more likely to accept blockchain tech that has no associated currency. This would mean losing the benefits of easy value transmission, but keeping the easy recording of an immutable, replicated ledger for the transmission or dissemination of information.

Read more here: http://www.coindesk.com/bitcoin-etf-rejection-whats-next-wall-street/

Nassim Taleb explains why you are right to worry about terrorism and ebola

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When several cases of Ebola were reported in the U.S. in 2014, the experts told us not to worry. After all, the odds of an epidemic were small. When there are terrorist attacks, the experts tell us not to worry. After all, more people die from falling off ladders than they do from terrorism.

But as Taleb asks, if you read in the paper that 10,000 people were killed yesterday, would you assume a terror attack or a huge spike in the incidence of ladder accidents?

Also, is Ebola rare because it is intrinsically rare, or is it rare because we worry about it and then take precautions? And if we stopped taking precautions, how many people could die?

Frequency is not how you measure risk for catastrophic events. Click To Tweet

Frequency is not how you measure risk for catastrophic events. Nassim Taleb explains how you should understand and view these risks in a quick and easy 10-minute video.

Enjoy.

OpenDoor Needs (or certainly should want) A Hedge

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OpenDoor.com has been getting a fair amount of press, and for good reason. First, they seem to have raised a fairly significant chunk of money. Second, they are bringing some of the change that the real estate market has needed for a long time. A new real estate ecosystem appears to be emerging and OpenDoor is a big part of it. Click To Tweet

Much of the initial press on OpenDoor focuses on one critical point. OpenDoor must, by its nature, hold a decent sized inventory of homes at all times. As fast as they might be in buying and selling, they cannot sell homes they don’t yet own, so they will have to own homes pretty much all the time. This leaves them with an exposure to downturns in real estate prices. Depending on the size of the inventory, the level of leverage they use and the volatility of the markets in which they operate, they could have a dangerous exposure to real estate.

In the analysis that follows, certain statements are made regarding OpenDoor’s operation. Some come from publicly available information, but some are assumptions based on public information and logic. Nothing here should be considered a definitive statement of the inner workings of the company.

Inventory Turns

OpenDoor buys homes quickly and has developed methods that will allow them to sell quickly, as well. If their model for valuing homes is good, and I would bet it is, they will be offering homes at something close to the right price. They offer 24-hour self-guided open houses. Finally, having bought for a good price, they can even offer the home for a bit less than they think it is really worth. But with all this, they will still have a few homes that don’t move and they will always have an inventory.

What the rapid turnover of inventory really does is reduce the level of price risk relative to revenues. It does not reduce risk relative to inventory. The faster homes can be disposed of, the higher the revenue in any given time period, hopefully creating an acceptable ratio of revenue to risk. But, all the same, there is an inventory and a risk.

Informational Advantage

Another advantage they have is a constant stream of information about the market. At any given moment, they will know how many homes are being offered to them. One imagines that this data is being fed into their valuation algorithms, giving them a better sense of value at a very high frequency. Similarly, they will know how quickly homes are selling, which can also be fed into the algorithm. They should end up with a better sense of the market than any other player.

Even with this information, there are drivers of price exogenous to their data and model. Political and economic events can push prices. Given the speed with which information is disseminated now, buyers could potentially dry up more quickly now and in the future than they have in the past. We might reach a point where something like the “flash crashes” that occur in securities markets begins to occur in real estate. And, in a rapidly declining market, lowering your offering price quickly is no guarantee of a sale. Perhaps, the model accounts for this, but perhaps it does not.

None of this is to suggest that OpenDoor’s is a bad model. Far from it. In fact, it is a great model, especially given the tools available.

The Hedge

Which brings us the next tool they need, an effective hedge. The need for a market for real estate derivatives, in which market participants could either hedge or acquire real estate exposure has been recognized for a long time. (See: Pricing and Index Considerations in Commercial Real Estate Derivatives, by Geltner and Fisher,
https://mitcre.mit.edu/wp-content/uploads/2012/11/real-estate-derivatives.pdf)
This market’s value to companies engaged in the algorithmic buying and selling of homes has not been recognized simply because such companies did not exist. But clearly, with a market in which it could hedge or transfer away its real estate exposure, OpenDoor would see both risk reduction and possible profit opportunities.

The most obvious use of a hedge is that the company could protect itself against calamity, in the form of significant and sharp drops in price. So, with an effective tool for hedging the price risk in its inventory, OpenDoor would avoid bankruptcy or, if not outright failure, the sort of huge hits to earnings and capital that cause stock prices to plummet.

But hedging would do more than avoid the worst. It would allow the company to optimize its cash flows. First, the company is using debt now, but the potential price risks in the model must be constraining the level of debt assumed to some degree. With protection from price drops, the company could assume a higher level of debt. Second, the company could, if it would be beneficial, hold some of its inventory longer in search of a higher sales price. If you always need to sell quickly, you will not realize the optimal price on your sale. There would still be a value in rapid turnover of inventory, but price protection could allow for a long holding period when it would be appropriate. At the moment, according to recent articles, the company is holding some homes that have not sold immediately.

Another use of a hedging market that is perhaps overlooked is seeking trading profits. If a liquid market for real estate derivatives existed, OpenDoor would have an informational advantage over other players. With the constant and real-time flow of offers to sell homes and buyers of homes, the company should have a better read on the direction and condition of real estate prices. But the information flow could go in both directions. Declines and rallies in the prices of real estate derivatives could, if OpenDoor were an active market participant, give them another timely input to their valuation model. Given how central their valuation model is to the business, any improvement should translate to more successful and less risky buying and selling in the market for real, physical homes.

OpenDoor has a great model, given the tool set available to them now. Clearly, the market is expecting success, given the way investment funds are flowing to the company. But with a market for real estate risk at their disposal, they could do even better, avoiding risk, optimizing timing and debt, and trading both physical and synthetic real estate effectively.

Sources:

Online real estate service OpenDoor raises $210M Series D despite risky financing model:
 https://techcrunch.com/2016/11/30/online-real-estate-service-opendoor-raises-210m-series-d-despite-risky-financing-model/

Startup Pays Cash to Buy Homes, Flip Them:
https://www.wsj.com/articles/startup-pays-cash-to-buy-homes-flip-them-1453423774

Pricing and Index Considerations in Commercial Real Estate Derivatives, by Geltner and Fisher:
https://mitcre.mit.edu/wp-content/uploads/2012/11/real-estate-derivatives.pdf

Maybe this is why Societe Generale gets in trouble every few years

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Maybe someone at SocGen should sit down and read The Black Swan.

If you are saying, “these are the black swans to look out for”, you don’t get it. You cannot predict a black swan. It is not just an unpredicted event, it is an unpredictable event.

You cannot predict a black swan. It is not just an unpredicted event, it is an unpredictable event. Click To Tweet

Read the full article here:
http://www.businessinsider.com/societe-generale-ominous-black-swan-chart