While the financial industry is something I’ve become more interested in lately, it’s not something you’ll see me post much about here. I will on occasion make a post, however, and this is the first such post. Don’t worry, this blog will remain 99% dedicated to LQ, Linux and Open Source and my foray into financials should give me additional insight into the viability of Open Source business models and a new perspective on some things.
It’s no secret that the economy is in horrific shape right now. I continue to think most of the damage control is focused in the wrong areas though and The real cause of the financial crisis, and the real solution hits the nail right on the head. You should read the entire post, but here’s the conclusion:
The mathematics of probability that govern the trade-offs of risk and reward are fundamentally counter-intuitive.
When investors see a fund manager generate a higher return than his competitors, they will move their money into that fund and out of the other ones. And money managers are rewarded based on the size of their fund, or the level of returns. The managers do not risk their own money. If they can provide a bigger gain for a few years, they win everything. They might even be lucky enough to be retired by the time their investors are paying the piper. The managers who have the discipline to understand and avoid the Martingale tricks will not be able to compete on the basis of their returns over a few years, and will eventually lose their funds and their jobs.
But many people managing large funds are men and women of integrity. They will not willingly expose their investors to total loss in order to line their own pockets with cash. Yet the system as it presently works does not allow them to compete without some kind of trade-off of long term risk versus short term reward. The solution that they usually flock to is to create such a complex Martingale system that they themselves cannot understand the longer term risk implications. As long as the mathematical analysis of the risk of ruin lies beyond the understanding of the CEOs, the money managing organizations can stay competitive by employing their latest version of a return-boosting Martingale, without admitting to themselves or to others that they have been peer-pressured into the financial equivalent of selling their soul to the Devil.
In the 80’s the emerging Martingales were called junk bonds and LBO’s. In more recent times they are known as mortgage backed securities and credit default swaps. You can regulate mortgages half to death and try to control what kind of risks various kinds of investment organizations are legally allowed to take. You can even forbid short selling and ban golden parachutes. But as long as managers are paid a percentage for managing other people’s money, they will compete with each other based on the returns they appear to generate. The pressure to create out-sized returns will eventually force them to invent the latest complex scheme which will have the same effect: eventually the investors lose it all. Complex financial structures will once again emerge that even the best professional investors cannot fully understand. People will always move their money into the places that give the best return over a few years, no matter how many times they are warned with the disclaimer that “past performance is no indication of future returns.” And eventually the crisis that results will reach global dimensions beyond the means of a government bailout, especially if part of the risk managing strategy becomes counting on bailouts happening every decade or so.
The only solution is to forbid money management as we know it.
That fact that we’re not only ignoring this root issue, but putting many of the people that helped caused the problem in charge of fixing problem is quite vexing.
Next is By the Numbers – How 2008 Shakes Out. The post is filled with data, but suffice it to say things don’t shake out well. A couple snippets::
-33.84% The percentage loss in the Dow industrials, worst since 1931, third-worst in history.
-38.49% The percentage loss in the S&P 500, worst since 1937.
-40.54% The percentage loss for the Nasdaq Composite Index, worst in history.
126 The number of up days on the S&P 500 in 2008.
126 The number of down days on the S&P 500 in 2008. (The difference, of course, is that on the down days, the market lost an average of a kajillion points.)
28 The number of Dow industrials components ending lower on the year. The outliers were Wal-Mart Stores and McDonald’s.
15 The number of Standard & Poor’s 500-stock index members that ended the year in positive territory. This is the worst breadth for the S&P going back to 1980; second-worst was 2002, when 131 stocks, or 26% of the issues, rose on the year.
18 The number of daily 5%+ moves on the S&P 500 in 2008.
17 The number of 5%+ moves on the S&P 500 between 1956 and 2007.
6 The number of days in 2008 that rank among the Dow’s top 20 up days and top 20 down days in terms of percentage change. (The leader, with 10 appearances, is 1932.)
-17.7%.The performance of the S&P’s consumer staples sector — the best performer among the S&P’s 10 industry sectors.
Yikes! Lastly, while things are getting tough (and are going to get tougher IMHO). It’s clear that solid companies/people and ideas will still get funded, even in this economic climate. On that note, congratulations to Evan on securing funding for identi.ca. Evan is a great guy and identi.ca has a ton of potential.
–jeremy
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