PDF VERSION
Of all measures to value stocks, the PEG (Price to Earnings Growth rate) ratio is one of the most incorrect. It should be completely ignored.
A PE (Price to Earnings) ratio is based on what a company made in revenues and earnings the previous year. The theory is that customer habits are predictable, and what you sold in revenue and earned in profit last year, you can at least repeat that this year. This works okay as a company gets bigger, because buyers have patterns; and if buyers bought an average of X dollars worth of stuff from the company last year, they are likely to buy X worth of stuff this year as well (or this could stretch out over several years-they may purchase X dollars worth of stuff every 5 years, and since there are many customers doing this in a staggered fashion, you can still predict revenues and earnings every year). Most businesses are based on repeat customers, and the PE ratio captures that well-the predictability of yearly revenues and profits is nothing but a predictability of repeat customers. However, the company needs to be quite big (e.g. at least 10 billion dollars revenue per year in the US) for you to be able to say this with confidence, or should have a subscription model or a contractual purchase model (predictable revenue streams), where barriers to switching are high. If this is not the case, what you earned last year (or made in revenues) has little to do with what you will earn this year, because your revenues can be very different. Because buyer behavior is not 100% predictable, they are not locked in, and you can't extrapolate what happened last year to this year.
With the PEG ratio you are bringing in the growth rate (of revenues or earnings) as another variable. Predicting the revenues and earnings of a company is hard enough when thought of year over year, but growth rates cannot be predicted or extrapolated at all. That a company grew at 15% for the last 3 years year-over-year, doesn't mean that the next year it will grow 15%. Similarly, a company which didn't grow at all for the last 3 years doesn't mean that it won't grow this year. Growth rates are very volatile, and are not based in the logic of repeat customers, predictable revenue streams, etc. which the actual revenues and earnings are based on. Mathematically speaking, the growth rate is the derivative of earnings or revenues with time, and the pattern of this derivative is highly unpredictable, and has nothing to do with the predictability of the original revenue or earnings.
Previous low growth rates do not extend to lower growth rates in the future, nor do historical high growth rates extend to high growth rates in the future. The PEG ratio is a completely idiotic invention in evaluating stocks. Please stop using it.
Showing posts with label taleb. Show all posts
Showing posts with label taleb. Show all posts
Seat belts, air bags, helmets, baby seats, children in the back seat only- where safety data is invented to scare humanity
I have followed the laws of putting seat belts on when driving in several countries. The safety boards (NHTSA in the US, for example) choose data which suits their safety narratives to force hapless citizens to wear seat belts, buy cars with air bags, and wear helmets when riding bicycles and motorcycles. Most of it is useless stuff being forced on you, which will hardly reduce your chances of death or serious injury, as I will try to show here.
The first seat belt laws were for drivers only, where the argument was that in a crash, the driver bangs their chest against the steering wheel; and a seat belt would hold the driver in place and prevent a very serious injury to the rib cage. Seat belts were made compulsory for drivers of all cars. However, passengers in the cars, even in the front, were not required to wear seat belts, because they do not have a hard object, the steering wheel, right in front and so close to them.
The safety experts saw the success of their publications and latched on to the idea. The standard argument used by this group of people is "you can never be too safe". Since they could convince government agencies that a seat belt was a good idea for drivers, they created more studies and data to show how seat belt saved lives and prevented serious injuries not just for the driver, but for the front seat passenger as well. In a few years, the government agencies made seat belts compulsory for front seat passengers as well.
Fast forward a few years and the logical next step was to create data and statistics to prove how much it would benefit if we forced the back seat passengers to wear seat belts. Seat belts were made compulsory for all four passengers.
Somewhere along the line the simple waist belt was thought to be too little protection-and larger belts which run over your shoulder in addition to tying you up at the waist were made compulsory.
An astute researcher (or a company) saw this and said that the children were not tied into the seat belts very firmly; they invented a baby seat. The purpose of this seat was to tie a baby very uncomfortably into it; and since man loves babies more than adults, the governments quickly fell for this data and made it mandatory that all babies ride in these seats. Even mothers who wore seat belts could not carry their babies in their laps; they had to tie up the poor baby next to her in the baby seat.
Airbags were made compulsory in cars in late 1990s. Some children in the front seat died because of the airbags opening on them (faulty airbags, small shocks, etc). The irony of a feature which itself kills people was completely ignored. Faulty airbags are a constant source of injuries even to adults.
To prevent airbag related child deaths in front seats, the government agencies made it mandatory that all children below 8 years of age be carried only in the back seat of the car. If they were babies less than 3 years old, they were tied into baby seats; if they were more than 3 years old, they could sit in the back seat, but always with the seat belt on. The natural desire of a parent to have a child at her side was sacrificed to the "scientific" judgement of the safety experts. Many babies have died because the parent left their car in a hurry and forgot that they had the baby with them (you would not forget if the baby was in the front seat, but you are much more likely to do so if the baby is in the back seat and sleeping). Once again, a rule which probably killed more babies than it saved (babies in the back seat, tethered to a special baby seat) has been instituted as a requirement for drivers.
Even if your car doesn't have an airbag, someone thought (and proved with data) that babies in these baby seats and children were still not safe in the front. So they were forced in the back seat for all cars.
All this has happened between 1980 and 2017 (I am writing this in 2017), in a span of about 40 years. Essentially, every 10 years, there has been a major safety regulation forced upoin people by governments worldwide.
How is this data taken? I looked at several of these studies, which proved that seat belts saved lives, etc.. The studies have major flaws in them. I will not criticize the data study by study, but the major problem with many studies is that car accidents have so many different variations in real life, that very little good conclusions can be drawn from looking at just a few of those accidents. Others are full of simulated conditions in a test lab, which have not much to do with the extremely large number of different real life accident scenarios.
I also don't see any logic in putting seat belts on heavy trucks and buses. I can't imagine a major accident with such heavy vehicles where a seat belt will save the driver's or the passengers' lives. The vehicle itself is their best protection. If the vehicle can't protect them, I don't think a seat belt can.
The vehicle is also a major protection for the driver and the passengers for smaller cars. Adding a little bit of extra protection with a seat belt or an air bag doesn't change the probability of dying or serious injury, in my opinion. The only exception would be for the driver with a steering wheel-with the risk of the steering wheel hitting her ribs. For future cars which may not have a steering wheel, a seat belt for even the driver is not necessary.
Or, if we continue on the safety bandwagon, to play the devil's advocate-I think the next step would be to put helmets for all passengers in cars. Let's take it even further-why not extend helmets to people walking on the road as well? Or better still, let's just have custom metallic iron-man style suits for everyone, and in the morning when we get up, we should be compulsorily made to put an iron-man suit which is all body protection. You obviously need to get a custom iron-man suit for each of your children. So the future of humanity will be everyone dressed in metallic iron-man suits walking around safely, riding their cars safely, and the little kids will be going to school in their iron-man suits so that they cannot be harmed by any accident at all! I am sure we will have future researchers showing how much safer we become by all these things. You can make up data to suit your needs. Formula 1 (F1) drivers put seat belts, a helmet and iron-man style suits-to keep themselves safe. But there's no need to subject the general public to this as a rule, because F1 races have a very high probability of accidents, unlike real life. The way we are going, it seems the F1 suits will be the norm for all of humanity, in the name of safety. Hey, you never can be too safe, the safety experts say.
Wearing a helmet will certainly improve my safety-but is it worth it? The probability of someone hitting her head in her adult life is rather low, and the discomfort of having a helmet on at all times must be weighed carefully against this probability. Because this probability is low and difficult to calculate (notwithstanding the researchers who will come up with something anyway), it is better for the government agencies to not make laws for these low probability events. If an individual decides to walk around all her life with a helmet, it is her choice; but there's no need to make it compulsory for everyone.
If seat belts were as beneficial as they like us to believe, you would see a massive collapse in deaths and injuries once seat belt laws were instituted. You do not see this-the number of deaths remains about the same (with its natural variation) and the institution of seat belt laws has not lead the significantly less number of deaths for adults and children. The argument that they would be even more if you didn't have these laws (figures say they would be between 10% and 100% more...basically come up with random estimates) seems bogus to me, because of the reasons mentioned above.
I was in Osaka, Japan recently, and enjoyed how mothers would ride bicycles with their babies freely in the suburbs of Japan without helmets on themselves or their children. Japan has one of the highest life expectancies in the world, if not the highest. Clearly if they are able to do this, we should realize that bike helmets are not necessary, and should not be made obligatory. If people decide to put them on it is their choice.
Takada, one of the biggest makers of air bags, had to recall millions of vehicles worldwide because of faulty airbags. I will deliberately not quote the data there which led the highway authorities to conclude that the bags are faulty-but it is sufficient to say that a feature which was designed to save lives may also causing deaths. While it is true that if the number of deaths due to faulty airbags were much lower than the number of lives saved due to the airbags, we may support airbags, but as I have said earlier, the "evidence" as to how many lives air bags have saved is rather inconclusive. Absent this, to put a fairly complicated piece of equipment which doesn't work properly all the time, the air bag, inside the car sounds like a bad idea to me. Air bags are also additional cost to everyone-the more unnecessary safety features are added to a car, the more the costs go up.
Note that these are completely different from rules made to prevent someone drunk driving a car. They risk the life of other people on the streets if they drink and drive, and rules against drunken driving are good for society. Even though a drunk driver has a low probability of getting into an accident, the very fact that they can harm other members of the society makes it necessary that they be restrained from this behavior. However, if they drink themselves silly and fall off their porch it is their right; and the government does not need to make rule for that. You have the right to hurt yourself, but not other people.
In summary: Seat belt rules, baby seat rules, children in the back seat only, air bags, helmets, etc. are unnecessary rules by an over-eager and overreaching government. The data is fudged, inconclusive, and cannot be relied upon because it does not simulate real life conditions of how accidents happen in real life in thousands of different ways-and these protection and safety features must be decided by people at the individual level, not shoved down people's throats by a government agency.
The first seat belt laws were for drivers only, where the argument was that in a crash, the driver bangs their chest against the steering wheel; and a seat belt would hold the driver in place and prevent a very serious injury to the rib cage. Seat belts were made compulsory for drivers of all cars. However, passengers in the cars, even in the front, were not required to wear seat belts, because they do not have a hard object, the steering wheel, right in front and so close to them.
The safety experts saw the success of their publications and latched on to the idea. The standard argument used by this group of people is "you can never be too safe". Since they could convince government agencies that a seat belt was a good idea for drivers, they created more studies and data to show how seat belt saved lives and prevented serious injuries not just for the driver, but for the front seat passenger as well. In a few years, the government agencies made seat belts compulsory for front seat passengers as well.
Fast forward a few years and the logical next step was to create data and statistics to prove how much it would benefit if we forced the back seat passengers to wear seat belts. Seat belts were made compulsory for all four passengers.
Somewhere along the line the simple waist belt was thought to be too little protection-and larger belts which run over your shoulder in addition to tying you up at the waist were made compulsory.
An astute researcher (or a company) saw this and said that the children were not tied into the seat belts very firmly; they invented a baby seat. The purpose of this seat was to tie a baby very uncomfortably into it; and since man loves babies more than adults, the governments quickly fell for this data and made it mandatory that all babies ride in these seats. Even mothers who wore seat belts could not carry their babies in their laps; they had to tie up the poor baby next to her in the baby seat.
Airbags were made compulsory in cars in late 1990s. Some children in the front seat died because of the airbags opening on them (faulty airbags, small shocks, etc). The irony of a feature which itself kills people was completely ignored. Faulty airbags are a constant source of injuries even to adults.
To prevent airbag related child deaths in front seats, the government agencies made it mandatory that all children below 8 years of age be carried only in the back seat of the car. If they were babies less than 3 years old, they were tied into baby seats; if they were more than 3 years old, they could sit in the back seat, but always with the seat belt on. The natural desire of a parent to have a child at her side was sacrificed to the "scientific" judgement of the safety experts. Many babies have died because the parent left their car in a hurry and forgot that they had the baby with them (you would not forget if the baby was in the front seat, but you are much more likely to do so if the baby is in the back seat and sleeping). Once again, a rule which probably killed more babies than it saved (babies in the back seat, tethered to a special baby seat) has been instituted as a requirement for drivers.
Even if your car doesn't have an airbag, someone thought (and proved with data) that babies in these baby seats and children were still not safe in the front. So they were forced in the back seat for all cars.
All this has happened between 1980 and 2017 (I am writing this in 2017), in a span of about 40 years. Essentially, every 10 years, there has been a major safety regulation forced upoin people by governments worldwide.
Flaws with these studies
How is this data taken? I looked at several of these studies, which proved that seat belts saved lives, etc.. The studies have major flaws in them. I will not criticize the data study by study, but the major problem with many studies is that car accidents have so many different variations in real life, that very little good conclusions can be drawn from looking at just a few of those accidents. Others are full of simulated conditions in a test lab, which have not much to do with the extremely large number of different real life accident scenarios.
I also don't see any logic in putting seat belts on heavy trucks and buses. I can't imagine a major accident with such heavy vehicles where a seat belt will save the driver's or the passengers' lives. The vehicle itself is their best protection. If the vehicle can't protect them, I don't think a seat belt can.
The vehicle is also a major protection for the driver and the passengers for smaller cars. Adding a little bit of extra protection with a seat belt or an air bag doesn't change the probability of dying or serious injury, in my opinion. The only exception would be for the driver with a steering wheel-with the risk of the steering wheel hitting her ribs. For future cars which may not have a steering wheel, a seat belt for even the driver is not necessary.
Or, if we continue on the safety bandwagon, to play the devil's advocate-I think the next step would be to put helmets for all passengers in cars. Let's take it even further-why not extend helmets to people walking on the road as well? Or better still, let's just have custom metallic iron-man style suits for everyone, and in the morning when we get up, we should be compulsorily made to put an iron-man suit which is all body protection. You obviously need to get a custom iron-man suit for each of your children. So the future of humanity will be everyone dressed in metallic iron-man suits walking around safely, riding their cars safely, and the little kids will be going to school in their iron-man suits so that they cannot be harmed by any accident at all! I am sure we will have future researchers showing how much safer we become by all these things. You can make up data to suit your needs. Formula 1 (F1) drivers put seat belts, a helmet and iron-man style suits-to keep themselves safe. But there's no need to subject the general public to this as a rule, because F1 races have a very high probability of accidents, unlike real life. The way we are going, it seems the F1 suits will be the norm for all of humanity, in the name of safety. Hey, you never can be too safe, the safety experts say.
Wearing a helmet will certainly improve my safety-but is it worth it? The probability of someone hitting her head in her adult life is rather low, and the discomfort of having a helmet on at all times must be weighed carefully against this probability. Because this probability is low and difficult to calculate (notwithstanding the researchers who will come up with something anyway), it is better for the government agencies to not make laws for these low probability events. If an individual decides to walk around all her life with a helmet, it is her choice; but there's no need to make it compulsory for everyone.
If seat belts were as beneficial as they like us to believe, you would see a massive collapse in deaths and injuries once seat belt laws were instituted. You do not see this-the number of deaths remains about the same (with its natural variation) and the institution of seat belt laws has not lead the significantly less number of deaths for adults and children. The argument that they would be even more if you didn't have these laws (figures say they would be between 10% and 100% more...basically come up with random estimates) seems bogus to me, because of the reasons mentioned above.
I was in Osaka, Japan recently, and enjoyed how mothers would ride bicycles with their babies freely in the suburbs of Japan without helmets on themselves or their children. Japan has one of the highest life expectancies in the world, if not the highest. Clearly if they are able to do this, we should realize that bike helmets are not necessary, and should not be made obligatory. If people decide to put them on it is their choice.
Takada, one of the biggest makers of air bags, had to recall millions of vehicles worldwide because of faulty airbags. I will deliberately not quote the data there which led the highway authorities to conclude that the bags are faulty-but it is sufficient to say that a feature which was designed to save lives may also causing deaths. While it is true that if the number of deaths due to faulty airbags were much lower than the number of lives saved due to the airbags, we may support airbags, but as I have said earlier, the "evidence" as to how many lives air bags have saved is rather inconclusive. Absent this, to put a fairly complicated piece of equipment which doesn't work properly all the time, the air bag, inside the car sounds like a bad idea to me. Air bags are also additional cost to everyone-the more unnecessary safety features are added to a car, the more the costs go up.
Note that these are completely different from rules made to prevent someone drunk driving a car. They risk the life of other people on the streets if they drink and drive, and rules against drunken driving are good for society. Even though a drunk driver has a low probability of getting into an accident, the very fact that they can harm other members of the society makes it necessary that they be restrained from this behavior. However, if they drink themselves silly and fall off their porch it is their right; and the government does not need to make rule for that. You have the right to hurt yourself, but not other people.
In summary: Seat belt rules, baby seat rules, children in the back seat only, air bags, helmets, etc. are unnecessary rules by an over-eager and overreaching government. The data is fudged, inconclusive, and cannot be relied upon because it does not simulate real life conditions of how accidents happen in real life in thousands of different ways-and these protection and safety features must be decided by people at the individual level, not shoved down people's throats by a government agency.
Fooled by Randomness-Egregious Errors Example, and Morality of Private Medicine
There is some cardiologist who is trying to say that switching the clock to daylight savings time leads to increased risk of heart attack. He has all the "Data" to prove this.
The sad thing is is that this guy probably makes hundreds of thousands of dollars cutting open people, doing angioplasties, open heart surgeries, etc..and has no idea about correlations not being causation.
If he tried to correlate his increase in heart attacks with the size of the left kidney of the patient, or the amount of coca cola someone drinks per day, etc. etc. He will see some other pattern. After seeing the pattern, he will come up with an explanation, a story, a scientific explanation he would call it-to make us understand why there is an increase of heart attacks, for example, after drinking 1 liter of coca cola per day.
His basic assertion is "Sandhu examined about 42,000 hospital admissions in Michigan, and found that an average of 32 patients had heart attacks on any given Monday. But on the Monday immediately after springing the clock forward, there were an average of eight additional heart attacks, he said."
News report here
and
Here
He even suggest doing further research in Hawaii and Arizona, which do not shift the clock for daylight savings time, to confirm his findings-leaving open the field for more fools to follow his footsteps. The research was presented at some American College of Cardiology conference.
My rule is to stay away from novel, cutting edge procedures in medicine. Something which has not been around for more than 30 or 50 years, please don't trust it at all. These guys are experimenting on you, and you pay them for it! Worse still, there is no money-back guarantee in medicine-if things go bad they still keep the money. And the worst part-you sign a document saying you cannot even sue them for damages if things go wrong.
The medicine monopoly is the most organized extortion scheme in the world (where there is little public medicine, e.g. in US, Chile, Canada). The patient has no rights, no promises-they only pay money and hope that they are cured. The other side, the medics-have a free ride on the rest of humanity.
---
The moral hazards of private medicine are further shown by the recent controversy of Gilead's new pill for Hepatitis C. The treatment is going to cost US $ 84,000! Click here for details. No one is able to see the inhuman part about this-how can you stiff someone of so much money when they have a severe health problem? Isn't society there to help the poor and needy? Or the government?
The argument given by these pharma companies is that they need the money to continue innovation and science. Bollocks! They are doing this to establish their monopoly. The governments and even the courts fall for this logic (in a previous post I covered how Monsanto does this the Justice system of all countries)..and everyone wants to pay these pharma companies to do more top-notch research, science, innovation etc.
Instead of preventing the formation of monopolies, the governments and courts end up assisting them. Such are the wily arguments of the merchants, Smith would say...and the monopoly spirit of these mercantile companies continues 200 years after Smith published the Wealth of Nations. As covered before, all patents and exclusive FDA approvals do this-establish the monopoly of these companies, at the expense of the citizens, who are stuck with paying $84K for a drug, or simply carrying around the illness with them forever.
And no-one seems to see the inhumanity in Gilead's asking this exorbitant amount of money. If a man is dying, he will pay $100K for a glass of water, and that's what these people are doing. They are trying to charge the dying man $100K for a gllas of water, and the goverment, patent and court system is actively supporting this charge, in the name of increasing innovation and science (a spurious argument, as I have already shown in a previous post).
For these cardiologists, and all these people who look for data and causes of things, Taleb's Fooled by Randomness should be mandatory reading. In fact it should be mandatory reading for everyone in University-so they don't mistake correlations for causality. The sheer volume of possible correlations confuses them into thinking they are on to something-they are all children of randomness. They underestimate the power of chance.
The sad thing is is that this guy probably makes hundreds of thousands of dollars cutting open people, doing angioplasties, open heart surgeries, etc..and has no idea about correlations not being causation.
If he tried to correlate his increase in heart attacks with the size of the left kidney of the patient, or the amount of coca cola someone drinks per day, etc. etc. He will see some other pattern. After seeing the pattern, he will come up with an explanation, a story, a scientific explanation he would call it-to make us understand why there is an increase of heart attacks, for example, after drinking 1 liter of coca cola per day.
His basic assertion is "Sandhu examined about 42,000 hospital admissions in Michigan, and found that an average of 32 patients had heart attacks on any given Monday. But on the Monday immediately after springing the clock forward, there were an average of eight additional heart attacks, he said."
News report here
and
Here
He even suggest doing further research in Hawaii and Arizona, which do not shift the clock for daylight savings time, to confirm his findings-leaving open the field for more fools to follow his footsteps. The research was presented at some American College of Cardiology conference.
My rule is to stay away from novel, cutting edge procedures in medicine. Something which has not been around for more than 30 or 50 years, please don't trust it at all. These guys are experimenting on you, and you pay them for it! Worse still, there is no money-back guarantee in medicine-if things go bad they still keep the money. And the worst part-you sign a document saying you cannot even sue them for damages if things go wrong.
The medicine monopoly is the most organized extortion scheme in the world (where there is little public medicine, e.g. in US, Chile, Canada). The patient has no rights, no promises-they only pay money and hope that they are cured. The other side, the medics-have a free ride on the rest of humanity.
---
The moral hazards of private medicine are further shown by the recent controversy of Gilead's new pill for Hepatitis C. The treatment is going to cost US $ 84,000! Click here for details. No one is able to see the inhuman part about this-how can you stiff someone of so much money when they have a severe health problem? Isn't society there to help the poor and needy? Or the government?
The argument given by these pharma companies is that they need the money to continue innovation and science. Bollocks! They are doing this to establish their monopoly. The governments and even the courts fall for this logic (in a previous post I covered how Monsanto does this the Justice system of all countries)..and everyone wants to pay these pharma companies to do more top-notch research, science, innovation etc.
Instead of preventing the formation of monopolies, the governments and courts end up assisting them. Such are the wily arguments of the merchants, Smith would say...and the monopoly spirit of these mercantile companies continues 200 years after Smith published the Wealth of Nations. As covered before, all patents and exclusive FDA approvals do this-establish the monopoly of these companies, at the expense of the citizens, who are stuck with paying $84K for a drug, or simply carrying around the illness with them forever.
And no-one seems to see the inhumanity in Gilead's asking this exorbitant amount of money. If a man is dying, he will pay $100K for a glass of water, and that's what these people are doing. They are trying to charge the dying man $100K for a gllas of water, and the goverment, patent and court system is actively supporting this charge, in the name of increasing innovation and science (a spurious argument, as I have already shown in a previous post).
For these cardiologists, and all these people who look for data and causes of things, Taleb's Fooled by Randomness should be mandatory reading. In fact it should be mandatory reading for everyone in University-so they don't mistake correlations for causality. The sheer volume of possible correlations confuses them into thinking they are on to something-they are all children of randomness. They underestimate the power of chance.
Financial sector earnings as options (volatility) selling
If you have followed the financial sector at all in your life-u see a recurring theme. Banks, brokers, insurance companies make good money quarter after quarter, and then in one or two quarters lose very large amounts of money-sometimes losing all they made in many years! Some of them gone under in one quarter alone. This is was explained very clearly by Taleb in his book-Fooled by randomness.
The crisis in financial markets since last summer has shows this so nicely, AGAIN. Socgen, Wall Street brokers, Citibank, UBS, CFC---u name it, each has contributed it's massive fat share to the financial sector losses in the world. Banks seemingly disconnected to subprime crisis in the US--banks in Japan, China, and India-have lost money on a financial crisis supposedly started by dislocations in the US subprime market.
That is a good/logical explanation, but I dont think that it is the right explanation.
Anytime you see a steady payoff period after period, and then a big loss in one period-it reminds you of the profit/loss profile of an options seller. The options seller is short volatility---makes small amounts of money for long periods of time, and then has big losses sometimes. Financial sector earnings are the same.
What happens is that markets become used to low volatility-smaller and smaller swings in asset prices. To get the same returns then, if you are a market maker at a bank or a broker-you have to leverage more. Or you take more liquidity risk, credit risk, etc-which deceptively looks cheaper to take! The classic Taleb's turkey-the turkey gets more and more confident as it is fed more and more-and it's confidence is at it's highest just before Thanksgiving day.
Lower volatility is the norm-but one wants to be prepared for the black swan of high volatility out there! The only way to do this is to control leverage-a fixed percent of equity-and be very mindful of other risks-liquidity risk, and credit/default risk the two important ones.
The subprime crisis is just an excuse for a period of high volatility. It is hard to prove that it is THE REASON for higher volatility. Any asset price going down can be attributed to high volatility (bursting the internet bubble, russian default, mexican peso crisis)-but if you have an options seller's profile in your overall portfolio-you will lose big when volatility suddenly spikes. The reason is not known, not is it important. The risk demons you have in your portfolio-of liquidity risk and credit risk-come to bite you hard when volatility shoots up. Bids disappear, bid/ask spreads widen, it becomes impossible to sell or buy in size.
In a few years when all this "crisis" wouldve passed-the press will find another reason for the next crisis. Surely it will happen after a period of low volatility, goldilocks scenario-as we saw in the beginning of 2006.
It is very insightful of Taleb to write about this-he reminds us of banks and brokers losing everything they make in many years in a bad quarter, and this seems to happen with remarkable periodicity! Jim Rogers was also shorting financials in 2006---what a great call by these guys!
Will such a massive collapse in the financials finally wake up people to realize that the financial sector in the US is an overpaid lot---the salaries of many of these funky managers need to come down quite a bit? Will the returns going forward in the financial sector lag the market? Only time will tell. But at least this should serve as a big wake up call to all investors in the financial sector.
Sanjay
The crisis in financial markets since last summer has shows this so nicely, AGAIN. Socgen, Wall Street brokers, Citibank, UBS, CFC---u name it, each has contributed it's massive fat share to the financial sector losses in the world. Banks seemingly disconnected to subprime crisis in the US--banks in Japan, China, and India-have lost money on a financial crisis supposedly started by dislocations in the US subprime market.
That is a good/logical explanation, but I dont think that it is the right explanation.
Anytime you see a steady payoff period after period, and then a big loss in one period-it reminds you of the profit/loss profile of an options seller. The options seller is short volatility---makes small amounts of money for long periods of time, and then has big losses sometimes. Financial sector earnings are the same.
What happens is that markets become used to low volatility-smaller and smaller swings in asset prices. To get the same returns then, if you are a market maker at a bank or a broker-you have to leverage more. Or you take more liquidity risk, credit risk, etc-which deceptively looks cheaper to take! The classic Taleb's turkey-the turkey gets more and more confident as it is fed more and more-and it's confidence is at it's highest just before Thanksgiving day.
Lower volatility is the norm-but one wants to be prepared for the black swan of high volatility out there! The only way to do this is to control leverage-a fixed percent of equity-and be very mindful of other risks-liquidity risk, and credit/default risk the two important ones.
The subprime crisis is just an excuse for a period of high volatility. It is hard to prove that it is THE REASON for higher volatility. Any asset price going down can be attributed to high volatility (bursting the internet bubble, russian default, mexican peso crisis)-but if you have an options seller's profile in your overall portfolio-you will lose big when volatility suddenly spikes. The reason is not known, not is it important. The risk demons you have in your portfolio-of liquidity risk and credit risk-come to bite you hard when volatility shoots up. Bids disappear, bid/ask spreads widen, it becomes impossible to sell or buy in size.
In a few years when all this "crisis" wouldve passed-the press will find another reason for the next crisis. Surely it will happen after a period of low volatility, goldilocks scenario-as we saw in the beginning of 2006.
It is very insightful of Taleb to write about this-he reminds us of banks and brokers losing everything they make in many years in a bad quarter, and this seems to happen with remarkable periodicity! Jim Rogers was also shorting financials in 2006---what a great call by these guys!
Will such a massive collapse in the financials finally wake up people to realize that the financial sector in the US is an overpaid lot---the salaries of many of these funky managers need to come down quite a bit? Will the returns going forward in the financial sector lag the market? Only time will tell. But at least this should serve as a big wake up call to all investors in the financial sector.
Sanjay