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July 29 - August 13, 2018
but it attracted little interest in 1952, or, for that matter, for more than two decades after Markowitz’s article was published. In those days, judgments about the performance of a security were expressed in terms of how much money the investor made or lost. Risk had nothing to do with it.
The destruction of wealth in the bear markets of 1973–1974 was awesome, even for investors who had thought they had been investing conservatively. After adjustment for inflation, the loss in equity values from peak to trough amounted to 50%, the worst performance in history other than the decline from 1929 to 1931.
Markowitz makes no mention of the word “risk” in describing his investment strategy. He simply identifies variance of return as the “undesirable thing” that investors try to minimize. Risk and variance have become synonymous. Von Neumann and Morgenstern had put a number on utility; Markowitz put a number on investment risk.
The major markets outside the United States are usually tracked by an index published by Morgan Stanley & Company that covers Europe, Australia, and the Far East. This index is known as EAFE for short;
Dating the book
William Baumol, the author of the paper demonstrating how long-term trends in productivity regress to the mean, calculated as late as 1966—fourteen years after the appearance of “Portfolio Selection”—that a single run to select efficient portfolios on the computers of that time would cost from $150 to $350, even assuming that the estimates of the necessary inputs were accurate.
Some investors, and many portfolio managers, do not consider a volatile portfolio risky if its returns have little probability of ending up below a specified benchmark.c
Then Kahneman and Tversky offered a choice between taking the risk of an 80% chance of losing $4,000 and a 20% chance of breaking even versus a 100% chance of losing $3,000. Now 92% of the respondents chose the gamble, even though its mathematical expectation of a loss of $3,200 was once again larger than the certain loss of $3,000. When the choice involves losses, we are risk-seekers, not risk-averse.
“The major driving force is loss aversion,” writes Tversky (italics added). “It is not so much that people hate uncertainty—but rather, they hate losing.”6 Losses will always loom larger than gains. Indeed, losses that go unresolved—such as the loss of a child or a large insurance claim that never gets settled—are likely to provoke intense, irrational, and abiding risk-aversion.7
One of the insights to emerge from this research is that Bernoulli had it wrong when he declared, “[The] utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.”
When the issue was framed in terms of an unemployment rate of 10% or 5%, the vote was heavily in favor of accepting more inflation to get the unemployment rate down. When the respondents were asked to choose between a labor force that was 90% employed and a labor force that was 95% employed, low inflation appeared to be more important than raising the percentage employed by five points.
The failure of invariance is far more prevalent than most of us realize. The manner in which questions are framed in advertising may persuade people to buy something despite negative consequences that, in a different frame, might persuade them to refrain from buying. Public opinion polls often produce contradictory results when the same question is given different twists.
Loss-aversion combined with ego leads investors to gamble by clinging to their mistakes in the fond hope that some day the market will vindicate their judgment and make them whole. Von Neumann would not approve.
At the beginning of the year, the professor plans for a generous donation to his favorite charity. Anything untoward that happens in the course of the year—a speeding ticket, replacing a lost possession, an unwanted touch by an impecunious relative—is then charged to the charity account. The system makes the losses painless, because the charity does the paying.
Keeping this concept in mind when moving into a new home, Kahneman and his wife bought all their furniture within a week after buying the house. If they had looked at the furniture as a separate account, they might have balked at the cost and ended up buying fewer pieces than they needed.
In each of Redelmeier and Shafir’s experiments, the introduction of additional options raised the probability that the physicians would choose either the original option or decide to do nothing.
Ambiguity aversion means that people prefer to take risks on the basis of known rather than unknown probabilities.
major Boston money manager agrees: “If you buy comfortable-looking . . . stocks like Coca Cola, you’re taking very little career risk because clients will blame a stupid market if things go wrong.”
We might dub the members of this group the Theory Police, because they are constantly checking to see whether investors are obeying or disobeying the laws of rational behavior as laid down by the Bernoullis, Jevons, von Neumann, Morgenstern, and Markowitz.
Richard Thaler started thinking about these problems in the early 1970s, while working on his doctoral dissertation at the University of Rochester, an institution known for its emphasis on rational theory.
investors resort to these deviations from rational decision-making because they believe that limiting their spending on consumption to the amount of income they receive in the form of dividends is the way to go; financing consumption by selling shares is a no-no.
One side of our personality is an internal planner with a long-term perspective, an authority who insists on decisions that weight the future more heavily than the present. The other side seeks immediate gratification. These two sides are in constant conflict.
Thaler and DeBondt demonstrated that, when new information arrives, investors revise their beliefs, not according to the objective methods set forth by Bayes, but by overweighting the new information and underweighting prior and longer-term information.
In part because of fear of decision regret and in part because of myopia, investors price the stocks of troubled companies too low in the short run when regression to the mean would be likely to restore most of them to good health over the long run. By the same token, companies about which recent information has indicated sharp improvement are overpriced by investors who fail to recognize that matters cannot get better and better indefinitely.
in The General Theory of Employment, Interest and Money, Keynes describes the stock market as, “. . . so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.”
The second problem in relying on evidence of superior management skills is that winning strategies tend to have a brief half-life.
Derivatives go back so far in time that they have no identifiable inventors: no Cardano, Bernoulli, Graunt, or Gauss. The use of derivatives arose from the need to reduce uncertainty, and surely there is nothing new about that.
Frank Knight once remarked, “Every act of production is a speculation in the relative value of money and the good produced.”
In theory at least, speculators in commodities will make money over the long run because there are so many people whose financial survival is vulnerable to the risks of volatility. As a result, volatility tends to be underpriced, especially in the commodity markets, and the producer’s loss aversion gives the speculator a built-in advantage.
Much of the famous Dutch tulip bubble of the seventeenth century involved trading in options on tulips rather than in the tulips themselves, trading that was in many ways as sophisticated as anything that goes on in our own times.
The opprobrium attached to options during the so-called tulip bubble was in fact cultivated by vested interests who resented the intrusion of interlopers onto their turf.
An ingenious risk-management contract was issued on June 1, 1863, when the Confederate States of America, hard up for credit and desperate for money, issued the “7 Per Cent Cotton Loan.” The loan had some unusual provisions that gave it the look of a derivative instrument.3 The principal amount was not repayable in Confederate dollars nor was it repayable at the Confederate capitol in Richmond, Virginia. Instead, it was set at “3 Millions Sterling Or 75 Millions Francs” and it was repayable in forty semiannual installments in Paris, London, Amsterdam, or Frankfurt, at the option of the
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Many people are willing but unwitting buyers of options. Anyone who has ever taken out a mortgage with a prepayment privilege owns an option.
At the time, he was studying economics on the side under the guidance of Franco Modigliani of the MIT faculty, who would later earn a Nobel Prize in economics.
fischer black
the Chicago Board Options Exchange opened for business in April 1973, just one month before the Black-Scholes paper appeared in print.
The CBOE now boasts one of the most technologically sophisticated trading centers in the world. It consists of a spacious trading floor, a basement with an acre and a half of computers, enough wiring to reach twice around the Equator, and a telephone system that could service a city of 50,000.
1990s
They had all done some selling during the bad week that preceded October 19, and most of them got out either at or only slightly below their designated floors. But the selling took place at prices far lower than anticipated. The dynamic programs that drove portfolio insurance underestimated the market’s volatility and overestimated its liquidity.
capped the loss at $27.5 million but, if everything worked exactly right, could reduce the loss to only $3 million. Prospect theory predicts that people with losses will gamble in preference to accepting a sure loss.
These derivatives also were created by Bankers Trust, whose full-page ads in business and financial publications proclaimed, “Risk wears many disguises. Helping you see beneath its surface is the strength of Bankers Trust.”
Later bought by deutsche bank
James Morgan, a columnist for the Financial Times, once remarked, “A derivative is like a razor. You can use it to shave yourself. . . . Or you can use it to commit suicide.”
While Bankers Trust and the other dealers in derivatives were managing their books on the basis of Pascal’s Triangle, Gauss’s bell curves, and Markowitz’s covariances, the corporate risk-takers were relying on Keynesian degrees of belief.
Surprise is endemic above all in the world of finance. In the late 1950s, for example, a relationship sanctified by over eighty years of experience suddenly came apart when investors discovered that a thousand dollars invested in low-risk, high-grade bonds would, for the first time in history, produce more income than a thousand dollars invested in risky common stocks.
