Gill Eapen's Blog, page 74

Quantum finance

Two beautiful ideas at the turn of the century – general theory of relativity and quantum mechanics – provided those with imagination a reason to live during the bleak times of war and depression. They also fundamentally transformed how we analyze and understand the world around us. For many centuries before that, classical Physics helped advance our understanding of how objects that we can see and feel behave. However, those principles were applicable in a very limited context and these two insights broke the scope of human beings wide open.

Classical finance is in a similar situation. Most of the financial principles applied today by operating companies and financial institutions alike were developed in the 60s. They are useful in the manufacturing of well defined products such as soaps and automobiles. In this modern era, such businesses command a very small percentage of the overall economy. Most of the value created in the economy comes from information and knowledge led innovation. Application of classical finance in these companies is akin to using Newtonian mechanics to understand gravitational lensing or quantum tunneling. They, simply, are not applicable.

Why, then, are the information driven companies in hi-technology, life sciences, energy, aerospace and other such industries, using archaic classical finance to make critical investment decisions? Why are the investment banks that "advise," these firms use such archaic accounting notions such as EPS and accretion to support their recommendations to buy and sell companies? Why are the blue chip consulting firms, who knows almost everything, use massive spread sheets with prescriptive cash flows when they (should) know such forecasts are meaningless? The answer is that none of these players have any incentive to change the status-quo. Leaders of operating companies do not want to deviate from existing financial processes in their complex organizations for fear of doing something wrong. Investment bankers just want to initiate M&A as their fees are critically dependent on such transactions and consulting firms just want to consult with large number of people spending long hours pouring over meaningless numbers.

The maintenance of status quo finance in a world that has changed is destroying significant value. Part of the blame has to go to the business schools who are stuck in education content that is at least 50 years old.

Have one's cake and eat it too?

A recent study, supported by a grant from the NSF, makes a bold statement. Apparently, the authors have found a way to detect bubbles in "real time," based on the simple premise that asset prices follow random walk. When asset prices are "not following," random walk, the authors argue, bubbles already exist or are just round the corner.

This sounds simplistic enough. After all it was just a few years ago that rock star monetary policy geniuses proclaimed "irrational exuberance," and set out to deflate the bubble in finely crafted holes in the "bubble," after it became obvious to most second graders. It was not quite "real time," it was after the train had left the station and the doors were closed for many years. Mathematicians and academics are likely too confident in their ability to see what others are yet to see. The only analogue to them, in practice, are hedge fund managers, who seem to harbor similar illusions.

Such predictions have to be viewed with extreme caution. The big brained academics may have to at least consider the possibility of the small brains of a large number of participants knowing more than their somewhat simplistic observation of a deviation from Geometric Brownian Motion could lead to. As previously observed by a Nobel prize winning economist, there are distinct differences between those in close proximity to fresh water and those adjacent to the brackish variety. The simplistic notion that market prices are driven by information and expectation of all participants may help some avoid wasting money on such research and predictions.

Mathematically detecting bubbles before they burst, Published: Monday, October 31, 2011 - 22:33 in Mathematics & Economics

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The real hedge funds

Hedge funds – a synonym for leveraged returns in good times and bankruptcy in others – have had a rough time lately. In corporate finance, the term "hedging" is used to mean risk management. However, one should not assume that the funds that carry the term "hedge," in their names have anything to do with such risk management. They behave more like gambling operations and their record shows spectacular destruction of value for investors.

As unsettling as the record of the rocket scientists of hedge funds have been, a more troubling issue is brewing in real companies. These companies, that make real things like computers, drugs and aircrafts, as opposed to moving money around, are also hedge funds in the same sense of the word. Each such operating company is a portfolio of real and financial assets. The real assets include manufacturing assets, R&D, intellectual property and know-how and financial assets include contracts and collaborations in addition to the more widely known – stocks, bonds and financial hedges.

Contemporary business education has prepared managers of these operating companies badly. They are taught the following two faulty concepts:

(a) Financial and real risk are separate and should be managed differently and by different people and departments.

(b) Companies should hedge risks they should not understand or have no control over.

First, financial and real risks in a company interact with each other and cannot be managed separately. Currently, corporate finance folks in glass towers manage "financial risks," and they have no desire to get their hands dirty thinking about such "tactical," issues as manufacturing and R&D. On the other hand, operations and R&D leaders have little respect for the suits, who according to them, understand nothing. Thus, they are naturally segmented – both psychologically and physically and accordingly they manage financial and real risks separately as if they are not related. This is not so.

Second, both financial and real asset managers do not understand certain type of risks. As they learned in their business education, they attempt to hedge the risks they do not understand, not realizing that the risks they are hedging may be related to other risks managed elsewhere in the company. An airline hedging fuel price risk is the classical prescription in this regard – but if fuel risks are positively correlated with the demand for its services, then hedging fuel price risk will actually increase enterprise risk – not reduce it.

Pouring over a set of standard "risk metrics," are not going to save those who do not understand risk holistically. Failure of hedge funds hurt only greedy investors and incompetent financial alchemists. More importantly, failure of real companies will hurt a larger swath of the economy. It is time managers of complex organizations woke up to real risk management. If they do not, the consequences are severe. (1)

(1) Flexibility : Flexible Companies for the Uncertain World

http://decisionoptions.info/DoBook/home.aspx

Type A deficiency

Type A individual is defined as ambitious, aggressive, business-like, controlling, highly competitive, impatient, preoccupied with his or her status, time-conscious, and tightly-wound. People with Type A personalities are often high-achieving "workaholics" who multi-task, push themselves with deadlines, and hate both delays and ambivalence (1). Conventional wisdom is that the type A personality is a precursor to success. Some business schools have discouraged applicants if they do not show type A in personality tests on the premise that it is a necessary condition for business success. Hard driving, high achieving CEOs of major corporations and their handlers in top tier consulting firms and investment banks all express such "winning" characteristics.

What is not clear, however, is whether Type A personalities actually add value to the organizations they are part of or to the society in general. In the last decade, it appears that most type A CEOs have destroyed value on both accounts. The decade before that it would not have mattered if you were type A or type Z (as in Zen), as just mere presence was sufficient for economic gains. Unfortunately, that was no indication of competence -  just the arrival of a technology that has broad impact on society – called the Internet.

The notion that type A personality shows leadership and business success has no supporting evidence. The truth is just the opposite. Dumb academics reading their own faulty research seem to have concluded on the personality characteristics that creates value. What they have actually unearthed is a leading indicator for white collar crime – as is immensely evident from the recent actions of the alumni of ivy heavens and consulting mavens.

(1) Wikipedia

Redefining education

Status quo education process is a leading indicator for the state of society in the future. Over the last century, education has been largely defined as the process of learning existing information. In many developing countries, the ability to regurgitate information and rote learning have been considered important capabilities. Accordingly, most of the materials and testing are designed around memorization. In certain developed countries, education took a turn in the 70s, when experimentation took over theorization. It has been more important to "see," what happens in the lab rather than imagining what could happen. These systems have churned out scientists, who have built large machines and labs to test the heck out of everything, in an attempt to find new things. Unfortunately, not many new insights have come from such routine experimentation.

Both systems – rote memorization of theoretical concepts and the free experimentation with little respect for theory – have brought education systems across the world to a standstill. They are imparting irrelevant skills in the next generation – some pay for it and others do not – but in both cases, they are wasting valuable time. The world has changed – it has no need for those who can memorize things without a fundamental understanding or for those who need experiments to understand how gravity works.

We are at the threshold of a major leap in which imagination and creativity hold a higher premium. There are no jobs waiting in the future for those able to memorize information (computers do that well) nor for those who require experiments to prove what have already been proven. Unless education systems around the world wake up to the new reality, a 10% unemployment could be an aspirational target in the future.

Welcome to the machine

"A machine manages power to accomplish a task" (1). Biological systems are good examples of machines – they consume energy to accomplish a task. Physical systems, built by humans, also fit the definition. However, the definition does not differentiate between the two – and that may be appropriate.

More broadly, assembly of biological systems – such as an ant colony or Wall Street – can be considered machines as well. Here the "task" is a slightly more complicated objective function such as aiding the queen ant to reproduce or maximizing personal wealth without other considerations. Since the energy consumed and the task accomplished can be measured, most machines can be attributed an efficiency factor. In the world of machines, only efficiency matters.

The performance of machines, thus, is the only thing that matters in the world. From the first bacterium to the complex biological systems of today, the fundamental architecture has remained the same. Set an objective and achieve it in the most efficient fashion possible. Later, humans, designed mechanical and organizational machines that reflected their own characteristics (2). All systems that exist today are machines. The task at hand are generally a simple subset such as the maximization of food, power and reproduction. The energy mostly come from a candle a few light minutes away, called the sun.

As humans seek "extra-terrestrial life," it may be instructive to measure the transformation efficiencies of such systems. If the efficiencies are about the same as we find on Earth, we may have found our cousins – something most scientists are very excited about. If it is higher, we may have come across a world of superior machines – fodder for most contemporary scientific fiction. However, if we find systems with lower transformation efficiencies, they may indicate societies more advanced than machines, ourselves.

(1) Wikipedia http://en.wikipedia.org/wiki/Machine

(2) Flexibility : Flexible Companies for the Uncertain World. http://is.gd/flexbook

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Drowning in particle soup

Illustrious physicists all around the world have been on the hunt for particles of all sizes, shapes and hues. Recently, some of them got together (1) to decide whether they should devise an experiment to detect the "sterile Neutrino," a particle that is "known not to interact" with any form of matter. The growth of particle zoo has been remarkable in the last 50 years – a period that has failed to provide any new insight into the structure and the content of the universe.

Particle Physics has been a very fertile area for mathematicians and those who aspire to publish papers that mere mortals cannot approach. The ones who contributed to the advancement of the field in the early part of last century, however, had believed and demonstrated that mathematical complexity is neither necessary nor sufficient for knowledge enhancement. In fact, it is just the opposite – mathematical masturbation without imagination does not really move the field forward. Hypothesizing another handful of "particles," that are hard to find is not a useful activity.

Complexity may help some to become famous and even win Nobel prizes – but real insights always came from simplification.

(1) Science 21 October 2011: Vol. 334 no. 6054 pp. 304-306, DOI: 10.1126/science.334.6054.304,The Sterile Neutrino: Fertile Concept or Dead End? Adrian Cho

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Optimistically pessimistic

A recent study (1) demonstrates that depression and proclivity to stress are linked to a specific gene. However, it appears that people can train themselves to escape the predetermined effects. In either case, it is instructive to note that optimism has a biological basis.

From an evolutionary perspective, optimism should have had survival benefits. 50,000 years ago, life was tough – dangerous animals in every dark corner, unfriendly clans elsewhere and internal fights for power and status. For humans, this was a treacherous life and many would have counted their 30 or so years of life span to oblivion, in pain. Optimism, rational or not, would have kept them going. With that, some were more likely to survive and pass on the genes. If this is true, then we should find a higher percentage of the population to be optimistic. Additionally, even if one is carrying the pessimistic gene, it is possible to mask it with behavior modifications.

It has been shown (2) that humans are generally irrationally optimistic and this is consistent with the selection hypothesis. However, it is unclear if those who made significant contributions to society in science and religion, can be considered inherently optimistic. Many great inventors appear to be introverts and socially less competent – indications that they were not driven by optimism. A large number of contemporary scientists are atheists, a trait not generally aligned with optimism.

This is a rich avenue for further study. Is pessimism a necessary condition for discovery as those carrying the unfortunate gene look for avenues of escape? Is optimism sufficient to design better societies?

(1) Psychologists Discover Oxytocin Receptor Gene's Link to Optimism, Self-Esteem. S. Saphire-Bernstein, B. M. Way, H. S. Kim, D. K. Sherman, S. E. Taylor. Oxytocin receptor gene (OXTR) is related to psychological resources. Proceedings of the National Academy of Sciences, 2011; 108 (37)

(2) http://www.popsci.com/science/article/2011-10/biased-brains-help-humans-always-look-bright-side-life

The exit syndrome

Investing in high innovation industries such as biotechnology and hi-technology has been treacherous business for many. Investors, without a clear understanding of how and where value is generated by high innovation industries, have been making incorrect decisions for many decades with predictable results. The relative ease by which all boats rose on a rising tide, in the 90s, compounded the problem as some still believe that their investment processes have no fault.

One trend has been investing closer to the "exit." For unknown reasons, these investors do not seem to understand that the exit is clearly marked for all market participants in red letters. That is to say, where the exit is for an investment is not the individual investor's secret. Both the market and the potential avenue to exit (say, a pharmaceutical company) both know the existence and characteristics of such exits. Thus, investing closer to the exit cannot be a "strategy" to increase shareholder value.

Another method used by the investors is to "drop in," a "proven" management team on top of a company with obscure intellectual property. The idea here is that the superstars are able to wash off the dirt on the diamond in the rough and sparkle the pockets of the impatient investors. Many are realizing that the "proof," that a management team succeeded somewhere does not necessarily mean that they will do it again.

Some have also been lured by "market size," as a proxy for economic value – especially for early investments. "Demographics," is the most mentioned reason for some early investments. Once again, the fact that large potential markets exist is not a sufficient condition for better investments.

A lack of understanding of how economic value is generated is at the heart of the falling productivity from investments in high innovation industries. Both the innovators and the investors are using incorrect proxies for the selection and design of products and technologies, based on experiences from the last century. The world has changed. Rote learning and application from history will not create value. New business models are needed to shock the industry out of its current doldrums.

Ref : Flexibility : Flexible Companies for the Uncertain World http://is.gd/flexbook

Free coasting

A recent article (1) describes why long term investments into renewable energy technologies are more beneficial to society than tactical schemes such as subsidies to enhance manufacturing efficiencies and carbon trading to curb production. This is an important insight with big policy implications.

Free rider problems are well known when benefits or disbenefits are shared by all participants regardless of personal costs. The cost of energy such as green house gases – are shared by all and hence innovators in renewable energy technologies pay a substantially higher price, making it non-economical locally. Policy makers, generally focus on tactical aspects to ameliorate the identified issues. But the economics of such actions, such as subsidies and the trading of the bad, are inferior to systematically solving the problem. The solution to the problem is not increasing the manufacturing efficiencies of status quo technologies or allocating the pain more uniformly, but inventing technologies that eliminate the issue.

Only innovation that creates technologies with orders of magnitude performance improvement to status-quo will solve the problem. This can only happen with targeted investments into the "unknown." Such policies have a higher economic value to society – but it has to escape the cost cutting accountants first. Band aids are unlikely to cure a wound that is already infected.

(1) Technology funding makes climate protection cheaper: Published: Monday, September 19, 2011 - 13:34 in Mathematics & Economics