Thursday, November 29, 2007

Tweedy, Browne's Semi-Annual Report

In a fascinating new book, A Demon of Our Own Design, author Richard Bookstaber, a “Wall Streeter” with over 20 years of quantitative trading experience, contends that financial innovation, complexity and globalization have combined to make our markets more crisis prone. He uses biology as a frame of reference for economic behavior, and contrasts the cockroach and the furu, a small perch-like fish, in a case study of risk management. He finds the survival of the cockroach over millions of years quite remarkable, especially in light of what he describes as their “coarse and sub-optimal behavior” when it comes to risk management. In essence, the cockroach has a rather simple defense mechanism: moving away from slight puffs of air. It completely ignores a wide range of other information and risks “…that one would think an optimal risk management system would take into account.”
He contrasts the sub-optimal behaving cockroach to the finely tuned and optimizing behavior of the furu, a once dominant, small, perch-like fish that survived in Africa’s Lake Victoria for thousands of years. The furu, over the centuries, became highly adapted to its environment, evolving into some 300 species and developing a myriad of skills, which allowed it to thrive and flourish in its habitat, rivaling “the finches that Darwin studied in the Galapagos.” It unfortunately fell victim to extinction when the Nile Perch was introduced by a Kenyan game fisheries officer into the lakes of Central Africa. Bookstaber points out that their “extinction was not the result of natural selection based on fitness in the usual sense; they were diverse and suited for almost every conceivable element of the Lake Victoria ecology.…Its path toward extinction was just a result of dumb luck that someone had introduced an alien species into its waters.”
The furu, on the other hand, is akin to today’s highly leveraged investor seeking to eradicate risk by fine tuning portfolios using probability theory in an attempt to ferret out and nullify any and all conceivable risks. Portfolios of high alpha generating, non-correlated assets are put together in a mosaic that is supposed to enhance return and lower volatility. With risk so theoretically constrained, investors are free to use leverage to exploit small market inefficiencies, allowing them to proverbially and safely “pick up dimes in front of steamrollers.” With massive amounts of individual and institutional capital having moved into these finely-tuned and highly leveraged strategies, Bookstaber contends that our capital markets will from time to time be confronted with liquidity shocks that could accelerate into full blown crises. Such was the case with the credit crunch in August.