I write about investing, technology, asymmetry and anti-fragility
Incentives are a powerful and often under-appreciated force. This is a great quote on the role of incentives in investing taken from an interview with James Rosenwald of Dalton Investments: “We feel that there is so much room for monkey business in running companies, but that management teams who own more shares than we do tend to focus on the success of the business rather than stealing from the company!”
The complete interview here is also a good read.
Bloomberg has an article today on Elihu Feustel who built a quantitative model to bet on tennis. According to the article, Feustel does not watch a lot of tennis matches but built his model using quantitative inputs to come up with “fair” odds for a match. If his odds are significantly different from what the market is pricing in, he places a bet. I thought there were a few interesting takeaways from his approach.
First, frequently it is possible to build a predictive quantitative model using a few key inputs that does significantly better than the prediction of experts. We have seen this in many different domains. See here for more examples.
Second, before getting carried away and applying this approach into a new domain (investing, for instance), it is important to understand the bounds of this approach. The set of outcomes of a tennis match or a political election is small and bounded. Many investing situations have large possible outcomes. This makes the modeling much more difficult.
Lastly, there may be multiple ways to trade a situation (using options for instance) so the problem is not just one of building a good model but also of figuring out the best trade that maximizes the expected return.
Despite some of the modeling problems, this is an approach worth thinking about more deeply in the context of investing. I have some thoughts on this and I plan to develop this approach in future.
Excerpt from the article:
“Tennis is an “attractive” sport to create an algorithm for because there are only two players in a singles match and statistics are freely available, according to William Knottenbelt, an associate professor of computing at London’s Imperial College. He co-wrote a tennis algorithm that he says would have made a 3.8 percent return on bets on 2,173 ATP matches in 2011.
Feustel, who says he puts in a 60-hour week checking and improving his model, works with a computer programmer and trader. The programmer trawls the Internet for data such as serve speed and break-point conversions. That’s plugged into the model which comes up with “fair” betting prices for scheduled games.
If those odds diverge from market prices, Feustel says, his trader — who lives outside the U.S. — will gamble as much as the market will allow at bookmakers including Pinnacle Sports, based on the Caribbean island of Curacao. That can be about $30,000 on a match result in later tournament rounds.”
Here is a link to the full article.
An example of hidden sources of fragility in the context of the Mexican Tequila Crisis. Key learning: “there is often an unknown vulnerability that only comes to light when a crisis erupts”
From Bamboo Innovator:
Tequila crisis: The dangers that only come to light in a disaster
Mexico’s “tequila crisis” is the quintessential example of the dangers of original sin. It also holds some cautionary lessons for those who believe the floating exchange rates and foreign borrowing abstinence of emerging markets will now inoculate countries from crises.
Money gushed into Mexico in the early 1990s but when Alan Greenspan, the Federal Reserve chairman, raised interest rates in 1994 the boom came to an abrupt end – and the dollar put pressure on the peso’s peg. By December the government tried to depreciate the peso but the currency crashed by more than 50 per cent.
The government was then brought low by its Tesebonos – peso bonds indexed to the dollar to reassure investors worried about a devaluation. When the peso collapsed the state was unable to pay the Tesebonos and had to be rescued by the US and the International Monetary Fund.
Today Mexico’s finances are transformed. About 80 per cent of its debts are in pesos, the currency floats and the central bank’s reserves are close to $180bn. Original sin is almost eliminated and the country is a firm investor favourite.
But the tequila crisis holds another vital lesson for policy makers and investors that draw comfort from the striking reduction in original sin: that there is often an unknown vulnerability that only comes to light when a crisis erupts.
Mexico’s crash in 1994 was exacerbated by the fact that the recently privatised local banks had themselves quietly accumulated huge exposures to Tesebonos. The currency devaluation therefore hammered the entire domestic banking sector instead of just hurting US banks, causing a ripple throughout Latin America.
Nor did Mexico look particularly vulnerable before the crisis struck. Although the current account deficit was wide and inflation elevated, the budget was not in terrible shape and growth was the fastest in four years in 1994. “Mexico was the poster child of Latin America,” says Prof Calvo. “But when liquidity bubbles burst it reveals weaknesses we cannot see now.”
If you were thinking of applying for the job, this is what Buffett is looking for!
Picking the right person(s) will not be an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.
Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.