5th June 2012: Roy Christopher’s 2012 Summer Reading List

Roy Christopher

 

Roy Christopher‘s annual Summer Reading List is a snapshot of “the salient texts of the zeitgeist.” RoyC’s 2012 list continues the tradition: rich insights from netizens, ethnographers, cultural luminaries, mentors and critics on the authors, ideas and frameworks that inform their work. An Edge or Iconoclasts-style dialogue/trialogue between some of these people would be very interesting to witness.

 

I spent a lot of the past year reading about Wall Street, writing draft zero of a political science PhD, and trading a small portfolio. My suggestions this year reflect this personal journey and are different to what I would normally contribute to RoyC’s list (and what other list contributors would probably read and sympathise with). There are books on geopolitical risk and salary negotiation, PhD texts on social science methods, and guides to investment, hedge funds, the visceral feel of trading, and institutional money management. Brenda Jubin’s awesome blog Reading The Markets informed some choices and Tadas Viskanta’s blog Abnormal Returns is now a daily visit. Hopefully, you’ll get a sense of how I approach and attempt to understand a knowledge domain on its own terms, even if some of the material is a very dry read.

 

The joys of this list include uncovering new things, and seeing things you are familiar with from a different vantage point. RoyC pointed out ethnographer and sociologist Tricia Wang‘s contribution to me: Brian Eno and Manual De Landa have also influenced me, and I will be checking out several of her banking and finance ethnographies. Likewise with RoyC, the cultural anthropologists Victor Turner and Arnold van Gennep are influences; I studied Aaron Wildavsky on risk; and I bought a secondhand copy of Anthony Wilden’s Systems and Structure from an old secondhand book shop in Melbourne.

 

I also participated in RoyC’s Summer Reading Lists for 2011, 2010, 2008, and 2007 (I missed 2009). You’ll see how my in-progress PhD project and other interests have evolved over the past five years. RoyC’s annual summer reading list now has a quality like Michael Apted‘s Up series: an unfolding, longitudinal journey through some interesting ideas of the early 21st century.

8th May 2012: Wall Street Reading List

Wall Street Bull

 

A selection of what I’ve been reading the past two years about Wall Street, and developing a personal capability in applied finance, investment, money management, and trading.

 

Learning

 

Emanuel Derman’s My Life As A Quant.

K. Anders Ericsson’s Development of Professional Expertise.

Malcolm Gladwell’s Outliers.

Michael Goodkin’s The Wrong Answer Faster.

Daniel Kahneman’s Thinking, Fast and Slow.

Victor Niederhoffer’s The Education of a Speculator.

George Soros’s The Alchemy of Finance and Soros on Soros.

Josh Waitzkin’s The Art of Learning.

 

Risk

 

Aaron Beck’s Red-Blooded Risk and The Poker Face of Wall Street.

Peter Bernstein’s Against The Gods.

Andy Busch’s World Event Trading.

Aswath Damodaran’s Strategic Risk Taking.

Satyajit Das’s Traders, Guns and Money and Extreme Money.

Francis X. Diebold, Neil A. Doherty and Richard J. Herring’s The Known, The Unknown, and the Unknowable in Financial Risk Management.

John C. Hull’s Options, Futures, and Other Derivatives (8th edition).

John C. Hull’s Risk Management and Financial Institutions (3rd edition).

Ari Kiev’s The Psychology of Risk.

Roger Lowenstein’s When Genius Failed and The End of Wall Street.

Guy P. Wyser-Pratte’s Risk Arbitrage.

William Poundstone’s Fortune’s Formula.

Andrew Ross Sorkin’s Too Big To Fail.

Nassim Nicholas Taleb’s Fooled By Randomness and The Black Swan.

 

Corporate Finance: Theory

 

Peter Bernstein’s Capital Markets and Capital Markets Evolving.

Donald Mackenzie’s An Engine, Not A Camera and Material Markets.

John McMillan’s Reinventing The Bazaar.

Perry Mehrling’s Fischer Black and the Revolutionary Idea of Finance.

 

Corporate Finance: Praxis

 

Tanya Beder and Cara Marshall’s Financial Engineering: Evolution of a Profession.

Simon Benninga’s Financial Modeling (3rd edition) and Principles of Finance With Excel (2nd edition).

Randall Billingsley’s Understanding Arbitrage.

Aswath Damodaran’s Applied Corporate Finance.

Martin S. Fridson and Fernando Alvarez’s Financial Statement Analysis: A Practitioner’s Guide.

Tim Koller, Richard Dobbs, and Bill Huyett’s Value: The Four Cornerstones of Finance.

Jeffrey Madrick’s Age of Greed.

Jeff Madura’s International Financial Management (11th edition).

McKinsey & Company, Tim Koller, Marc Goedhart and David Wessel’s Valuation (5th edition).

Jonathan Mun’s Real Options Analysis.

Justin Pettit’s Strategic Corporate Finance.

Simon Woolley’s Sources of Value.

 

Mergers and Acquisitions

 

Connie Bruck’s The Predators’ Ball.

Robert F. Bruner’s Deals From Hell.

Robert F. Brunner and Joseph R. Perella’s Applied Mergers and Acquisitions.

Bryan Burrough and John Helyar’s Barbarians At The Gate.

Joshua Rosenbaum, Joshua Pearl, and Joshua R. Perella’s Investment Banking.

 

Investment

 

Joseph Calandro Jr.’s Applied Value Investing.

William D. Cohan’s Money and Power.

Ken Fisher’s The Only Three Questions That Still Count.

Anti Ilmanen’s Expected Returns.

Alice Schroeder’s The Snowball.

Robert Shiller’s Irrational Exuberance (2nd edition).

Meir Statman’s What Investors Really Want.

Tadas Viskanta’s Abnormal Returns.

 

Money and Portfolio Management

 

John Abbink’s Alternative Assets and Strategic Allocation.

Harold Evensky, Stephen Horan, and Thomas Robinson’s The New Wealth Management.

Richard Grinold and Ronald Kahn’s Active Portfolio Management.

Andrew Kumiega and Benjamin Van Vliet’s Quality Money Management.

John Maginn, Donald Tuttle, Dennis McLeavey, and Jerald Pinto’s Managing Investment Portfolios.

David Smith and Hanny Shawky’s Institutional Money Management.

David Swensen’s Unconventional Success and Pioneering Portfolio Management.

Richard Tortoriello’s Quantitative Strategies for Achieving Alpha.

Ralph Vince’s The Handbook of Portfolio Mathematics.

Leonard Zacks’s The Handbook of Equity Market Anomalies.

 

Hedge Funds

 

Maneet Ahuja’s The Alpha Masters.

Steven Drobny’s The Invisible Hands.

David Einhorn’s Fooling Some People All of the Time.

Ari Kiev’s Hedge Fund Masters.

Sebastian Mallaby’s One Market Under God.

Richard C. Wilson’s The Hedge Fund Book.

 

Trading

 

Mike Bellafiore’s One Good Trade.

Peter L. Brandt’s Diary of a Professional Commodity Trader.

John F. Carter’s Mastering The Trade (2nd edition).

Jared Dillian’s Street Freak.

Robert Edwards, John Magee, and W.H.C. Bassetti’s Technical Analysis of Stock Trends.

Mark Fenton-O’Creevy, Nigel Nicholson, Emma Soane and Paul Willman’s Traders: Risks, Decisions, and Management in Financial Markets.

Ari Kiev’s Trading To Win.

Charles D. Kirkpatrick II and Julie Dahlquist’s Technical Analysis (2nd edition).

Edwin Lefevre’s Reminisces of a Stock Operator.

Michael Lewis’s Liar’s Poker and The Big Short.

John J. Murphy’s Technical Analysis and the Financial Markets.

Brett Penfold’s The Universal Principles of Successful Trading.

Jack D. Schwager’s series (Market Wizards, New Market Wizards, Stock Market Wizards, and the new Hedge Fund Wizards).

Brett N. Steenbarger’s Enhancing Trader Performance and The Daily Trading Coach.

 

Algorithmic, High-Frequency and Quantitative Trading

 

Thomas Bass’s The Predictors.

Paolo Brandimarte’s Numerical Methods in Finance and Economics.

Brian Brown’s Chasing The Same Signals.

Barry Johnson’s Algorithmic Trading and DMA.

David Leinweber’s Nerds on Wall Street.

Scott Patterson’s The Quants.

Rishi K. Narang’s Inside the Black Box.

Dessislava Pachamanova and Frank Fabozzi’s Simulation and Optimisation in Finance.

Edgar Perez’s The Speed Traders.

 

Photo: iHeylen/Flickr.

17th April 2012: Is Wall Street Inefficient?

Wall Street

 

New York University’s Thomas Phillippon has a new paper that reaches counterintuitive conclusions about Wall Street:

 

Historically, the unit cost of intermediation has been somewhere between 1.3% and 2.3% of assets. However, this unit cost has been trending upward since 1970 and is now significantly higher than in the past. In other words, the finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds and stocks, and it was certainly doing it more cheaply. This is counter-intuitive, to say the least. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan? [emphasis added]

 

Phillippon’s study of financial intermediation costs emphasises debt growth, hidden systemic risks and the growth in trading as a secondary market activity. The New Republic‘s Timothy Noah also emphasised trading in his write-up of Phillippon’s results. The paper’s problem is Phillippon’s reliance on the “neo-classical growth model” which argues that information technology, trading, and risk management should lead to lower costs and superior information about future prices. A second problem is that Phillippon explains growth in ‘informativeness’ as a key criterion variable but he does not adequately define it. A third problem is that the paper examines two key data points – 1900-1910 and 1980-2011 – without considering how the innovation pathways in financial intermediation have also changed (both in-period and across-period). For instance, Value at Risk looked like a great innovation in 1992 but it was re-evaluated in 2007-08 during the global financial crisis. A fourth problem is that prices in trading are not always about future prices, or even the fair market value of firms, but they can reflect the market-moving tactics of hedge funds and other firms. A fifth problem is that the inefficiencies that Phillippon identifies lie partly in the fees and incentives that the mutual industry charges investors as revenue generation (and Wall Street’s incentivisation through end-of-year bonuses). Thus, any evaluation of financial intermediation efficiencies should take current market practices into account.

 

If Phillippon had used a market microstructure framework then he might have reached different conclusions about the paper’s aggregate data. Specific firms are able to leverage information technology, trading, and risk management to gain an edge on other market participants. They extract alpha (returns made from active management above and beyond the market index returns or beta). This creates a ‘winner takes all’ dynamic in which a small group of efficient firms do exceedingly well. However, the Schumpeterian dynamics of inter-firm competition means that factors like information technology do not simply lead over time to greater efficiencies and lower costs, as they did with Wal-Mart. Quantitative finance firms like Jim Simon’s Renaissance Technologies, Clifford Asness’s AQR Capital and David Shaw’s D.E. Shaw & Company spend millions on infrastructure and proprietary research to outpace their competitors. This creates ‘informativeness’ in the form of private knowledge that Phillippon’s models probably could not measure. Is this really a misallocation of capital?

 

Photo: apertu/Flickr.

2nd March 2012: Media Narratives on Traders

Frankfurt Stock Exchange

 

The Baseline Scenario‘s James Kwak observes about financial trading:

 

The main reason why finance’s share of GDP has outstripped its production of intermediation services, according to [Thomas] Philippon, is a huge increase in trading volumes in recent years. Trading, of course, generates fees for financial institutions, with limited marginal social benefits. Yes, we need some trading to have price discovery. But if I sell you a share of Apple on top of the other 33 million shares that were traded today, is that really helping determine what the price of Apple should be? The more that financial institutions can convince us to trade securities, the larger their share of the economy, whether or not that activity improves financial intermediation. [emphasis added]

 

Kwak’s comment interested me for several reasons. I thought immediately of Philip Augar‘s trilogy of books on London’s transformation as a global finance hub (The Death of Gentlemanly Capitalism; The Greed Merchants; and Chasing Alpha). Kwak’s emphasis on intermediation — intermediaries who match lenders and borrowers — reminded me of the Smart Internet Technology CRC’s emphasis on strategies of first mover advantage, disintermediation (removing intermediaries), and end-user innovation. Finally, Kwak espouses a critical view of trading that resonates with Occupy The SEC and other Wall Street critics.

 

Traders’ usual response is that they provide the market with liquidity as well as price discovery, and that estimates of assets’ future values can vary.

 

The media has two dominant narratives about traders. First, traders are American Psycho-like psychopaths that ‘go rogue’. Second, proprietary traders at financial institutions and hedge fund managers can make exorbitant amounts of money. The first narrative occurs during recessions and on the discovery of major cases like Barings’ Nick Leeson or Societe Generale’s Jerome Kerviel. The second narrative occurs during the initial stages of macroeconomic booms and speculative bubbles. A New Yorker profile of private equity maven Stephen Schwarzman in 2007 captures the transition between the two narratives.

 

In September 2011, just as the Occupy Wall Street protests were unfolding, Germany’s Der Spiegel cited a study that appeared to prove the first narrative. Pascal Scherrer and Thomas Noll, two MBA students at University of St. Gallen, interviewed 28 Swiss traders, using “computer simulations and intelligence tests.” The study went viral and it was cited throughout the United States mainstream and financial media (including by my old boss Richard Metzger at Dangerous Minds with his acerbic wit). The authors aren’t easily accessible: a Google search brings up other people – an Australian post-doctoral fellow in tourism and a German software engineer. St. Gallen’s MBA program did not release the paper — but sources did reveal it was an MBA student assignment and not peer reviewed academic research.

 

Even without seeing it the Scherrer & Noll’s study raises questions: the kind that get asked in blind peer review and by research administrators and managers. Did Scherrer (“forensic expert”) and Noll (“a lead administrator at the Pöschwies prison north of Zürich”) have the financial markets background to contextualise what the traders were saying and why? Did their background potentially bias how they would interpret the data: looking for or interpolating certain correlations? What specific “computer simulations and intelligence tests” did Scherrer and Noll use? How were these tests framed for the trader participants? Is the data from two different groups — traders and psychopaths — truly, directly comparable? From where, how and whom did the psychopath data come from? Who else, apart from the psychopaths, was the control group? What other competing hypotheses or theories were tested? Are the test subjects institutional or day traders? What instruments and markets did they trade? What range of trading strategies did they use and why? What was their performance like during the study’s time period? You will find these aspects in the methods and research design section of most rigorous academic journal articles. It is why top journals now require academic authors to release the raw, de-identified data for others to examine.

 

Noll’s comments to Der Spiegel are revealing, when the above is taken into account. Some traders are “egotistical”: perceiving themselves to be entrepreneurs in a financial institution. Trading attentiveness can require high ego-involvement. Trading can be a solo activity — affecting the study’s variable of “readiness to cooperate” — although prop firms like SMB Capital do get their traders to cooperate in order to get synergistic, group effects. Traders are usually risk-seeking and aware of time-based competition so of course they were “were more willing to take risks” since careful risk management is essential to arbitrage and trading. Noll expressed surprise that traders sought “a competitive advantage” and “weren’t aiming for higher winnings than their comparison group.”

 

But this a sign to me that Noll misunderstood the traders and also the financial institution they worked in. Prop traders can gain 40-60% of their compensation through bonuses with the institution can change based on risk-adjusted performance. In essence, trading is about gaining competitive advantage in a zero-sum game — particularly in highly stochastic and volatile areas like currencies and commodities futures. This is why many traders read Sun Tzu‘s Art of War and Miyamoto Musashi‘s Book of Five Rings, or study non-cooperative game theory and behavioural finance. Then there’s why University of St. Gallen possibly released Scherrer and Noll’s study to the media: the MBA program emphasises “responsible leadership” and the study nicely fits with this institutional goal. However, it obscures other explanations for ‘rogue traders’, such as Adam Curtis noting in his documentary 25 Million Pounds that Barings Bank management likely knew of and endorsed Nick Leeson’s trading activities whilst they were profitable. For many people, Scherrer and Noll just confirmed what they already felt about Wall Street traders.

 

In reality, ‘traders as psychopaths’ is a media-created narrative. It can be traced to Gordon Gekko (Michael Douglas) in Oliver Stone’s film Wall Street (1987); to Ivan Boesky and Michael Milken; to Michael Lewis‘s autobiography Liar’s Poker (1989) about his time in Salomon Bros as a bonds salesman; and to George Soros and the 1992 United Kingdom currency crisis. In the 1980s, a healthier vision of the Masters of the Universe were traders like Martin Zweig and Victor Sperandeo. A decade later, Frank Partnoy‘s cautionary biography Fiasco (1999) refashioned the image for financial crises in Asia and Latin America. John Perkins’ Confessions of An Economic Hitman (2004) expanded this to the Washington Consensus. CNBC’s Jim Cramer morphed from a successful money manager to a television personality. Satyajit Das transitioned from writing guidebooks on financial derivatives to becoming an articulate media critic. Richard Bookstaber had a more nuanced and systemic view of hedge funds with A Demon Of Our Own Design. The latest addition to this narrative is Jared Dillian’s Street Freak (2011) on his experience at Lehman Bros. and the short-lived BBC series Million Dollar Traders starring Lex Van Dam and Anton Kreil.

 

Scherrer and Noll’s study appealed to people whose self-image of traders came from Gordon Gekko and Liar’s Poker. The collapse of Bear Stearns and Lehman Bros. during the 2007-09 global financial crisis — and the ‘too big to fail’ negotiations with financial institutions — now reinforce this self-image. A more realistic image of traders can be found in Ari Kiev and Brett N. Steenbarger‘s books on trading psychology; in the multi-author ethnographic study Traders; and in Jack D. Schwager‘s interview books which are ‘required reading’ for many traders. I’ve seen footage of traders’ live reactions to the 1987 stockmarket crash: the traders are shocked but they still react. There’s little room for ‘traders as psychopaths’ in contemporary high-frequency trading systems (which created fears around the 2010 ‘flash crash’). But the media narrative serves as a screening mechanism: it prevents people from finding out how trading really works or how its principles can be used elsewhere in their lives. If Scherrer and Noll really wanted “a sober and businesslike approach to reaching the highest profit” then they interviewed the wrong group: they should have talked with pension fund and private wealth managers in Switzerland, or with portfolio managers. This potentially introduces scope and levels of analysis limitations into Scherrer and Noll’s study (since fund and portfolio managers can act differently to traders).

 

Slate‘s Richard Beales illustrates the second narrative: billionaire hedge fund managers. Beales’ target is Ray Dalio, founder of Bridgewater Associates and author of a ‘Principles’ employee handbook (PDF) which The Wall Street Journal‘s Paul Farrell compares to capitalist philosopher Ayn Rand. Beales notes that hedge fund founders usually keep a low profile; are privately owned and more entrepreneurial than banks; and have a compensation structure more aligned with investors. The second narrative is really a subset of the ‘winner-takes-all’ dynamic in superstar economics. Milken, Zweig and Sperandeo in the 1980s, Soros in the 1990s, and John Paulson now are the financial equivaelent of superstars. Beales doesn’t cite hedge fund researchers like Andrew Lo or Sebastian Mallaby. He doesn’t mention the high failure rate of hedge funds or the survivorship bias in industry databases.

 

Which brings me back to Kwak’s original insight. His claim that financial markets are less efficient flies in the face of new systems that lead to smaller bid-ask spreads (high-frequency trading), and more diverse, targeted fund structures (mutual, hedge and quantitative trading). Rather, these developments have led to an interlocking network of funds and financial institutions who trade, at greater volumes and in more liquid instruments. In this network, the fund and portfolio managers, and the traders, occupy highly lucrative niches. Understanding how and why they are successful (or fail) has taught me some significant, actionable, and pragmatic knowledge.

 

Photo: saibotregeel/Flickr.

1st March 2012: Trading Insights For Academics

Chicago Board of Trade, 1971

 

In August 2011, I started trading a small market portfolio. I had read the trading literature and researched case studies on the hedge fund Long-Term Capital Management (PDF) and the April 2000 dotcom crash (PDF). Gradually, I began looking at academia in a new way beyond my experience as an administrator and researcher. Below are three tentative insights that trading can give to academics:

 

1. Every trader seeks an ‘edge’ to arbitrage. Every successful academic I know has cultivated an ‘edge’ over their careers that they become known for. They may have taught in a specific area and then had their careers take off when they got project management accreditation. They may develop expertise and then chair the relevant international association. I know different professors who specialise in research, competitive grants, and gaining industry partners for institutional consortia: they create alpha (active returns above the market benchmarks). I know early career and mid-career academics who have their own qualities, such as a well-formed research plan or a stream of journal publications. They transcend the notion of ‘performance relative to opportunity’ through conceptualising and then creating preferred futures instead of letting circumstances dictate their lives. They have all found a competitive niche that amplifies their talents. They refuse to buy-in to the institutional narrative around budget and resource allocative mechanisms. Other academics have made career limiting moves: being on too many committees; not keeping up with developments in their field; not reading the current research; or getting caught in administrative systems. Being aware of your ‘edge’ — what makes you different or unique — is vital.

 

2. In a negotiation/trade/transaction there are (at least) two sides. This is vital to remember in dealing with the Human Resources department and in negotiating contracts, counter-offers and incentives. The successful academics above who create arbitrage can frame these opportunities to reflect an institution’s enlightened self-interest. This requires an understanding of Machiavellian power politics, the ‘two cultures’ of administration and academics, patronage systems between professors and other academics, the shadow side of universities, and the way that incentive systems actually work. Academics who keep this in mind — who can see the same situation from multiple viewpoints — are more likely to get the outcomes that they want; to extract or create value in a situation; and to avoid career limiting moves and decision traps. Frameworks and tools such as decision trees, game theory, real options theory, and some knowledge of corporate finance and strategy can help. One of the biggest psychological shocks for young academics is the moment they realise that the institution does not always have their best or optimal interest at heart (as the academic would define it) and must be carefully bargained with.

 

3. Most traders lose; the casino/high frequency traders/proprietary traders/hedge funds/Goldman Sachs win. Academia is increasingly a ‘winner-takes-all’ game in which a few do very well and a lot of others work very hard for not the same rewards. As a research administrator, I hear the horror stories from academics about the demands placed on them and the broken processes and systems that they have to work with. Many academics are unsuccessful with Australian Research Council and other Category 1 grants: the ARC has a 17-20% success rate. Many academics are unable to conceptualise a research design that will get them into a top journal in their field or discipline. Performance-based metrics — designed with input from external consultants and a range of administrative staff — are increasingly the norm (as they have been for a decade in other industries and workplaces). These changes create dilemmas for senior management and games that get played throughout the institution. Examples I have recently seen include publishing fake conference papers; publishing in obscure journals like the Transylvanian Review of Administrative Sciences; and even running vanity presses to self-publish colleagues’ research. However, in the long-term these games are unsuccessful and do not convince university promotions committees: international standards have strengthened in the past 5-10 years. Knowing when and how to lose is a skill. Study carefully the strategies that successful academics use.

 

Keeping these insights in mind will help academics to create ‘for better’ outcomes.

 

Photo: patarnow/Flickr.

15th January 2012: Trading Books For 2012

On my possible reading list for 2012 from Wiley Finance:

 

1. Michael Goodkin’s The Wrong Answer Faster: the inside story of the quantitative finance firm Numerix and the physics models that Goodkin developed to model financial markets. I look forward to some backgammon tips.

 

2. Maneet Ahuja’s The Alpha Masters: an insider’s guide to the money management strategies of hedge funds — I hope it’s on a par with Andrew Lo’s research (MIT).

 

3. Jack D. Schwager’s Hedge Fund Market Wizards: the fourth book of interviews in Schwager’s hugely influential Market Wizards series — will it live up to the excellence and insight of the previous three books?

31st December 2011: Trading Books

Market Wizards: Interviews With Top Traders by Jack D. Schwager (Columbia, MD: Marketplace Books, 2006). (TS-3). Schwager’s interviews are frequently at the top of professional traders’ recommended reading lists for their insights into the personalities, backgrounds, decisions and different strategies of traders. Schwager’s follow-up books The New Market Wizards (Columbia, MD: Marketplace Books, 2008) and Stock Market Wizards (Columbia, MD: Marketplace Books, 2008) feature further informative interviews with different groups of traders. Useful for comparison with Brandt, Einhorn, Lewis, and Mallaby below.

 

The Big Short: Inside the Doomsday Machine by Michael Lewis (New York: Penguin Books, 2010). (TS-3). Lewis (Liars’ Poker, Moneyball) profiles the Wall Street analysts and hedge fund traders who foresaw the 2007-09 global financial crisis: Steve Eisman, Mike Burry, Greg Lippman, Charlie Ledley, Ben Hocket, John Paulson and others. The Big Short how credit default swaps and other synthetics of financial engineering were created. Lewis exemplifies how ‘contrarian’ traders think and make trading decisions about financial markets: there is enough journalistic reportage in this book to actually model the trading strategies. For details of J.P. Morgan’s creation of collateralised debt obligations see Gillian Tett’s Fool’s Gold (Little, Brown, New York, 2009). For details of John Paulson’s ‘Soros trade’ see Gregory Zuckerman’s The Greatest Trade Ever (Penguin Books, London, 2009). For the best account of the negotiations behind the 2007-09 global financial crisis, see Andrew Ross Sorkin’s Too Big To Fail (Viking, New York, 2009). For further analysis of the business cycle implications, see Nouriel Roubini and Stephen Mihm’s Crisis Economics (The Penguin Press, New York, 2010).

 

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby (London: Bloomsbury PLC, 2010). (TS-3). Mallaby’s history of hedge funds – financial vehicles that enable pooled investors to speculate on stock-markets – has interviews and historical details which are unavailable elsewhere. More Money Than God explores how hedge funds have evolved over the past four decades, from journalist Alfred Winslow to philanthropy. There are interviews with George Soros, Julian Robertson, Bruce Kovner, Paul Tudor Jones, John Paulson, and details of David E. Shaw’s firm D.E. Shaw and James Simons’ Renaissance Technologies: two ultra-secretive quantitative hedge funds. As with Jack D. Schwager’s series on traders, this is an invaluable book for understanding how hedge funds actually work and the motivations of their founders. For some of the best academic research (and influenced by Isaac Asimov’s Foundation series) see Andrew Lo’s Hedge Funds: An Analytic Perspective (Princeton University Press, Princeton, 2010). For a comparison with ratings agencies, see Timothy J. Sinclair’s The New Masters of Capital (Cornell University Press, Ithaca NY, 2008).

 

Fooling Some of the People All of the Time: A Long Short (And Now Complete) Story by David Einhorn (Hoboken, NJ: John Wiley & Sons, 2011). (TS-4). In 2002, hedge fund manager David Einhorn gave a speech advising investors to ‘short’ Allied Capital. Einhorn’s talk triggered a criminal investigation and maneuvers between Einhorn and Allied Capital. This book can be read as an investigation of corporate governance issues that foreshadowed the 2007-09 global financial crisis. Its primary value lies in revealing the research methods and decisions that a successful value-oriented fund manager uses; the accounting tricks that firms use; and how Kahneman’s biases and heuristics can influence hostile situations. If you want to understand the basics of corporate finance, valuation and fundamental analysis then see the McKinsey model in Tim Koller, Richard Dobbs, and Bill Huyett’s Value: The Four Cornerstones of Corporate Finance (John Wiley & Sons, Hoboken NJ, 2010).

 

Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading by Peter L. Brandt (Hoboken, NJ: John Wiley & Sons, 2011). (TS-4). Most trading books feature post facto selections of trade examples and market timing. Brandt’s diaries and technical analysis charts convey how difficult trading actually is; the importance of risk and money management; and the struggles to deal with Kahneman’s biases and heuristics. This book dispels the myths of day-trading success and much of the publishing books that Wiley Finance, McGraw-Hill and other publishers release.

 

Thinking, Fast and Slow by Daniel Kahneman (New York: Farrar, Straus & Giroux, 2011). (TS-1). Kahneman (awarded the 2002 Nobel Prize in Economics) and his late colleague Amos Tversky pioneered the study of psychological biases and decision heuristics. Kahneman distinguishes between System 1 (fast, emotional) and System 2 (slower, methodical, logical), and how these different cognitive systems affect us. An excellent primer on how to think, reason, and decide more effectively, which makes accessible over four decades of Nobel Prize-winning research. Effective trading is about making reasoned decisions in a fast, volatile environment. For an example of how event risk and volatility can affect decision-making and financial models, see Roger Lowenstein’s When Genius Failed (Fourth Estate, London, 2002) on the 1998 collapse of the hedge fund Long-Term Capital Management.

 

Unconventional Success: A Fundamental Approach to Personal Investment by David Swensen (New York: The Free Press, 2005). (TS-3). Swensen is the successful investment manager with Yale University’s endowment fund. Unconventional Success distills his insights on the investment process; how to develop an investment portfolio; the different asset classes; and the role of asset allocation over market timing (trading). Swensen — like John C. Bogle (founder of The Vanguard Group), Burton G. Malkiel (A Random Walk Down Wall Street), and others — recommends that you put most of your money into a low-cost index fund like Vanguard or Dimensional Fund Advisers. Swensen’s companion book Pioneering Portfolio Management (The Free Press, New York, 2009) deals with active managers in an institutional funds context. If you want to understand the institutional money management approach, see Richard C. Grinold and Ronald N. Kahn’s Active Portfolio Management (McGraw-Hill, New York, 1999) for quantitative and risk management processes, and Antii Ilmanen’s Expected Returns (John Wiley & Sons, Hoboken NJ, 2011) for asset allocation decisions.

 

The Predators’ Ball by Connie Bruck (New York: Penguin USA, 1989). (TS-3). In the 1980s high-yield or junk bonds led to a mergers and acquisitions bubble. Bruck profiles junk bonds trader and market creator Michael Milken (now a philanthropist) and the major deals that his firm Drexel Burnham Lambert financially engineered. The Predators’ Ball has substantive insights and journalistic reportage on Milken’s thinking and strategies, similar to Lewis (The Big Short) and Mallaby (More Money Than God). This period is also covered in the Adam Curtis documentary The Mayfair Set (1999). This is a cautionary tale of ethics and power: Milken essentially created and monopolized the junk bond market but acted unethically and was involved in the Ivan Boesky scandal. The epochal RJR Nabisco deal is covered in Bryan Burrough and John Helyar’s influential Barbarians At The Gate (Collins Business, London, 2008). For a comparison of Drexel Burnham Lambert with the private equity firm Kohlberg Kravis Roberts see George P. Baker and George David Smith’s The New Financial Capitalists (Cambridge University Press, New York, 1998).

 

Inside Job (Sony Classics, 2010). (TS-3). Charles Ferguson’s Academy Award-winning documentary dissects the 2007-09 global financial crisis and its roots in a housing speculative bubble, the failure to regulate derivatives markets, and a ‘winner takes all’ trading culture. Features interviews with George Soros, Nouriel Roubini, Raj Rajaratnam, and others that summarise complex issues.

 

Million Dollar Traders (BBC2, 2009). (TS-3). European hedge fund manager Lex Van Dam and ex-trader Anton Kreil supervise 8 novices who run a hedge fund in London’s Cass Business School for two months. Several weeks into the project, the 2007-09 global financial crisis begins, and each trader reacts in different ways. Interesting for its use of simulation learning, event arbitrage and how the various personalities deal (or don’t) with stressful situations and uncertain decision-making. In one sequence, the cameras reveal that Kreil is having instant chat messages with outsiders using a producer’s account: Van Dam may actually be trading against the novices.

 

The Mayfair Set (BBC, 1999). (TS-3). Adam Curtis (The Century of the Self, The Power of Nightmares, The Trap, All Watched Over By Machines of Loving Grace) profiles a group of entrepreneurs associated with London’s Clermont Club, including Jim Slater, James Goldsmith and Tiny Rowland. The Mayfair Set documents their stock-market deals and internecine fighting from the late 1950s to the 1980s mergers and acquisitions bubble in the United States. Curtis links together fears about national sovereignty, business cycles, financial innovation, media battles, and luck. Jim Slater’s Return To Go: My Autobiography (Weidenfeld & Nicolson, London, 1977) recounts the Slater Walker years whilst Geoffrey Wansell’s Tycoon: The Life of James Goldsmith (Grafton, London, 1987) is an insightful, semi-authorised account of how Goldsmith pioneered mergers and acquisitions raids and asset management techniques.

24th December 2011: Journal of Financial Markets: Observations

Last night, I read articles from the 2007-2012 issues of the Journal of Financial Markets (Elsevier). I check-in with this academic research to keep abreast of developments in market microstructure, trading mechanisms, and institutional trading strategies.

Some of the academic research findings I noted:

 

• Growth managers are momentum traders.

• Style neutral and value managers are contrarian traders.

• Trades with high price impact – medium sized orders, large trading volume, trade early in morning.

• Limited capital – traders tend to use momentum and value strategies.

• Morning losses for day-traders – afternoon selling trades – attempt to meet daily price targets.

• Psychological biases lead to correlated trading of individual investors – buy stocks with strong recent performance (momentum); refrain from selling stocks held for a loss; and net buyers of stocks with highly unusual trading volumes.

22nd December 2011: The Nihonbashi Working

The Nihonbashi Working

2:30-3:30pm, Tuesday 11th October 2011
Tokyo Stock Exchange building and TOPIX computer system area, Nihonbashi, Tokyo: http://www.tse.or.jp/english/

 

Preparation material: Nouriel Roubini and Stephen Milm’s Crisis Economics (on speculative bubbles); Rishi K. Narang’s Inside the Black Box  and Brian Brown’s Chasing The Same Signals (on quantitative trading); Sebastian Mallaby’s More Money Than God (on hedge funds); Joel Hasbrouck’s Empirical Market Microstructure (on market microstructure); Connie Bruck’s The Predators’ Ball (on Drexel Burnham Lambert and Michael Milken’s junk/high yield bonds); and ThomsonReuters’ Datastream and Sirca database services. I took Bruck’s book with me on the subway ride to the TSE.

 

Aims:

(i) Reflection on a personal ‘lost decade’ and prospective plans for self-sufficiency as defined in Uncle Setnakt’s Essential Guide to the LHP
(ii) Consideration of the initial period of the Mammon Project
(iii) Illustrative working to understand the TSE, in particular the TOPIX supercomputer system, and Bloomberg and ThomsonReuters services

Results
:

Nihonbashi’s power lies in the longevity of financial institutions and an evolving trading environment, in which computer algorithms, high frequency trading and machine learning shape financial markets rather than individual investors. Milken had two pivotal insights: (i) how to actively use academic research on junk/high yield bonds for trading opportunities and monopoly market creation; and (ii) how to structure and fund an autonomous organisation (with unethical consequences due to lack of corporate governance controls and effective institutional oversight). Bloomberg and ThomsonReuters illustrate the market-making role of information intermediaries.

 

The late 1980s stock and property bubble, and S&P and Moody’s downgrade of Victorian state government debt in October 1992 influenced my family’s finances, whilst the April 2000 dotcom crash curtailed plans to move to the United States. The ‘Black Swan’ cascade events of March-April 1998 were due to a failure to risk hedge publishing contracts, and to an unawareness of money management techniques. The demise of REVelation and 21C magazines; and the internal battles within The Disinformation Company Ltd, the Australian Foresight Institute at Swinburne University and the Smart Internet Technology CRC were due to different combinations of managerial principal-agent conflicts, moral hazard, exogenous shocks to funding, and a lack of institutional controls to prevent conflicts. Each organisation had some initial success; each also endured significant problems. The personal effect of this was to re-experience over a decade from 1998 to 2007 the rise and fall of several institutions in which I had made a significant time and personal investment. These experiences led to personal post-mortems also on the 1998 collapse of the hedge fund Long-Term Capital Management; the 1990s dotcom bubble; and DARPA’s plans for a terrorism futures market.

 

In the TSE, I resolved to develop a private, low-key, personal vehicle for long-term self-sufficiency, drawing on insights from active management, event-based arbitrage, tick data analysis of market trading and volatility, and money management. The ‘lost decade’ was reframed as an exploratory period required to build the knowledge base for the personal vehicle. The personal vehicle’s agenda then is to consolidate this exploratory period in practice, and build the personal resilience to avoid potential crises that could arise over the next 10-15 years.